Wednesday, February 10, 2010

Obamanomics and the Multiplier Effect

The Obama Administration, along with the usual Democrat suspects in congress, are in the process of cobbling together another stimulus plan which, given the colossal failure the first stimulus plan was, is being given a new title: a "jobs" bill. This latest fiscal fiasco, regardless of what innocuous name Obama wants to call it, will also fail. In today's American Thinker, Jeffrey Folks has written an interesting article in which he discusses the breathtakingly misplaced faith the Democrat Party places in the old Keynesian concept of the "multiplier effect":

Liberals are fond of referring to government spending as "investment." From Barack Obama on down, Democrats speak of investing in job creation, education, alternative fuels, high-speed rail, and every other pet project for which they can expect to receive lobbyist donations. As recently as February 3, the president announced yet another "investment" guaranteed to enhance "American energy independence" while creating "millions of jobs." No, this is not the initiative from April 22, May 5, or October 27 promising more or less the same thing. This is another initiative, with another enormous price tag.

Defending this dubious form of investment, liberal economists such as Alan Blinder fall back on the Keynesian theory of the "multiplier effect," according to which each dollar of government spending generates additional wealth as the increased monetary supply circulates throughout the economy. It is a lot like planting a handful of magic seeds and hoping to see a beanstalk shoot up to the sky.

The problem is that it costs the government a lot to plant those magic seeds, and too often government plants them in the wrong places.

I thought it would be useful to delve briefly into the multiplier effect (or government spending multiplier to which it is also referred) since Obamanomics relies so heavily on this deeply flawed and discredited Keynesian idea. The theory of the multiplier is relatively simple. The concept is based on the idea that every dollar the government spends will have a multiplicative effect on economic growth. For example, if the multiplier is assumed to be 1.5, every $10 dollar increase in government spending will increase the size of the economy by $15. It’s magic! Unfortunately, modern free market economists who have tested this theory empirically have failed to confirm it. In short, there is little or no reliable data on which to base it.

The basic problem is this. The government can’t spend money in a vacuum. It has to come from somewhere. There are three places government can get it. They can take it from me through taxation, they can borrow it, or they can print it (monetization). If they take it from me, any stimulative effect realized from the government spending the money is negated by the reverse effect which results from me not spending it. Government spending is also far less efficient than private sector spending so the reverse effect of me not spending the money is probably greater than the stimulative effect of government spending it, resulting in a net loss in economic growth.

The second source from which government can obtain funds is to borrow them by selling bonds in the open market. This too comes at a cost as the increased supply of bonds depresses bond prices resulting in higher interest rates. This is what economists refer to as the crowding-out effect. The crowding effect is perhaps the most insidious effect of increasing the national debt. When the government borrows money, they do so in the money market. The amount of money available to borrow is not unlimited.

Any money the government borrows means there is less money available for the private sector to borrow. There is no law that says the government gets first dibs, but effectively they do since their decision to borrow money is not dependent on the cost of borrowing (i.e. the interest rate). Government will take whatever they need, regardless of the cost. But, when they borrow money, the laws of supply and demand kick in. The increased demand for money by the government increases the interest rate or cost of that money to everybody else and thus, less private sector investment occurs.

Again, government doesn’t care about that cost but the private sector does. There is no reason for businesses to borrow other than to make money. Assume we have a business thinking about expanding. They want to build a new plant, for example. They look at the projected cost of the plant and the stream of projected revenues that plant will eventually generate. This analysis must show that the projected revenues will exceed the projected costs or the investment won’t take place. Anything that increases the cost of the investment decreases the probability that the investment will be profitable.

Interest rates are a huge cost to any capital investment. Higher government debt results in higher interest rates which results in less private sector investment taking place. Private sector investment leads to higher productivity and higher productivity is the only thing that raises living standards. Therefore, increased government debt leads to lower future living standards, period. In other words, government borrowing “crowds out” private sector borrowing, ultimately resulting in a lower future living standard than would otherwise occur absent government borrowing.

A third source of government funding is for the government to simply print money. This is called monetization. Monetization has the effect of diluting the value of a nation's money stock. Economists have a name for this: inflation. The more rapidly a government prints money, the more rapidly that nation's currency loses value. It doesn't take an economist to understand the folly of such a policy.

The declining value and importance of the dollar in the foreign exchange markets and the high price of gold tell us that investors are already factoring monetization into their future expectations. The Obama Administration, through Secretary of the Treasury Tim Geithner, deny that they will resort to monetization.

Of course they make this claim. No government ever admits they are monetizing the debt because that would result in a run on their currency as it's openly devalued. China suspects we are going to do this. So do other countries. Several countries are now threatening to stop buying US bonds and adopt another reserve currency or use an index of several currencies. If this happens, look for a rapid decline in the value of the dollar and the Fed will be forced to raise US interest rates to fight this, further hampering economic recovery.

Mr. Folks ends his article with the following:

Liberals like Barack Obama never seem to consider the effect of their colossal spending on the real economy. They believe that they can plant magic seeds that will sprout a beanstalk leading up to the sky, and that in the sky there exists a golden goose which will fund one grand welfare initiative after another. In reality, all we will possess after running up a $14-trillion debt is a hill of beans.

I couldn't have said it better myself. All Obama's plan will do is shift spending from the more efficient private sector to the inefficient public sector. The net result is that Obama's latest "stimulus" won't stimulate anything. It will result in more debt, fewer jobs, and lower future living standards as Governor Palin and other conservative leaders have been warning for the past year. In another example of just how clueless Obama is, today he's seeking advice on job creation from noted economist and captain of industry Al Sharpton. Need I say more?

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