The magic multiplier effect

When you plant a tree in the ground, it grows, producing seeds which become the source of new trees. But remember, trees can only grow where there are resources – water, sunlight and nutrients in the soil.

We can think about government investment in the same way. In a democracy, government spend happens because society chooses to invest in itself. It does this by sprinkling a few seeds into the economy, and if it hits the right spots then the economy will grow. Investing in people, in particular their health and education, tends to pay big time. In technical terms, health and education are areas where the fiscal multiplier is significantly greater than one, as this article shows.

So when the journalists ask, `how are we going to pay for it?’ The answer is, it pays for itself.

Let’s consider a specific example. We have to be careful because every case is different but only by looking at a specific case can we begin to understand how it might work. Suppose, our democratically elected government has a mandate to improve the health service, and in consultation with experts it decides that we need more doctors and nurses. Contrary to what most people think, the problem is not, how are we going to pay for the extra staff? Rather it is where are we going to find them, and what are they no longer doing now that they are doctors and nurses?

Let’s look at the money side first. Just like a bank, government does not need to collect money in order to make a payment. Just like a bank, it can `create’ money by issuing a credit which is balanced by a debt. This debt is cancelled by people paying taxes. However, this does not necessarily mean that to pay the extra doctors and nurses, the government will need to raise taxes. If the economy grows because of the additional investment in health, then tax revenues will rise and cover the extra spend without the need to raise tax rates.

There are limits, of course, and managing the economy is like managing a forest. Just like in the forest, we need water, sun and soil, in the economy we need people with knowledge and skills. We can delve a bit deeper with an even more specific example. Take a nurse called Charlie (could be a Charles or a Charlotte). In the age of austerity, Charlie gave up being a nurse because the hours were long and the pay was bad. Instead Charlie works in a factory making widgets. But work in the widget factory is not great either. Most of the workers are off sick with stress and mental health problems, so when in a new drive to improve health begins, Charlie decides to leave the widget factory and become a nurse again. Charlie is rather good at nursing and helps some old widget colleagues to overcome their problems and return to work. Productivity rises to such as extent that output is increased dramatically. Everyone pays their taxes and all the extra spend on health and more widgets comes back in the form of tax revenue, more than offsetting the extra government spend. Now that’s the magic multiplier effect!

Now you could argue, that the market could do this. The boss at the widget factory should have realised that Charlie would make a brilliant in-work psychologist. Except that it wasn’t happening. The market could not find the solution because the necessary skills and ability – in this case the boss – were not there. Contrary to the Hayekian dictum, the man on the spot does not always know best, sometimes, we need to combine the skills of the collective – private and public – to find solutions.

Comments

  1. Sean Danaher -

    Charles

    many thanks. Very nicely put. What is deeply sad is how the concept of a fiscal multiplier, which seemed widely known in the 1970’s has somehow drained from memory, through Neoliberal brainwashing perhaps.

    The slavish belief in the free market and “invisible hand” is a worry but ideal for the right-wing neoliberal view of the world.

    Things could go “pear shaped” very soon if Brexit goes badly. The worry is that as Ivan argues is that when it becomes clear that the system is not working, rather than embracing Neo-Keynesian or MMT, Britain moves to an even more extreme form of Neoliberalism.

  2. Graham -

    I would like to see the Govt set up an independent “think tank” to examine the effects of government spending, to include good estimates of the MME, such as on the NHS (which should also look at less tangible benefits, such as people being relieved of pain), but also to look at the hidden costs of some spending, such as on roads, which have good and bad effects, some of the latter including congestion, pollution and early death. They could also look at private sector spending where the government has to approve, such as Heathrow expansion, where I read that the State will also have to subsidise transport links, perhaps to the tune of £10-15 billion, plus increased pollution etc.

    1. Charles Adams -

      Good suggestion. The difficult part is that the economy is so interconnected, and costing externalities like pollution is very tricky. To some extent when you construct an economic model you will get the answers you wanted. However, if all the assumptions are clearly stated and the model reproduces previous data then progress could be made. I agree that much more could be achieved.

  3. Bat Sheetcrazee -

    You’d think that all those £20bn+ deficits from 2002-2018 would be paying for themselves by now if the theory stood up to real world testing.
    Here’s a question Charles: have you read the section of the Fournier and Johansson analysis of government spending programmes which reduce national income.

    1. Charles Adams -

      Fournier and Johansson write that:

      “Increasing the share of public investment in spending yields large growth gains. These gains are particularly strong for public investment in health”

      and

      “certain public spending items (public investment and education) boost potential growth”

      Specifically for the UK, the authors claim that “Increasing public investment (including R&D)” would be “positively significant” for growth.

    2. Andy Crow -

      Bat Sheetcrazee

      Are you though simply not taking into account that money supply needs to be balanced ?

      Money in, in the form of newly created money has to be balanced by the increased money out as tax take of increased economic activity. If some sectors of the economy are deviously avoiding or evading that part of the process and/or government doesn’t set tax rates correctly the deficit will not ‘pay for itself’.

      Counter cyclical (Keynesian) stimulus is similarly easy to implement when money needs to be injected into the economy, but the longterm there has to be the balancing repair of the finances when the good times roll. Governments like to take credit for creating the good times without facing the reality that they never last long.

      Biblical Joseph of technicolor dream coat fame, all those millennia ago explained the principle which we still ignore, and the seven year cycle has held good for a great deal of the time.

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