The technique of deficit finance and the multiplier reviewed

I am republishing below a post I wrote trying to explain the multiplier as an effective policy tool embedded in Keynesian deficit finance. It first appeared in my older blog on blogspot Harold Chorney political economist in the middle of the financial crisis.Alongside my post on my current blog on the multiplier it is I think a useful guide.It was posted here on haroldchorneyeconomist as Some notes on the multiplier, April 4, 2012.

The technique of deficit finance
January 17, 2008 11:30 pm

The stimulus package being discussed in Washington will temporarily increase the American federal government deficit in order to inject a positive fiscal impulse to the economy. There seems to be, perhaps understandably, a fair bit of confusion about how such a stimulus can work to counter the recessionary forces now underway in the American manufacturing, housing and financial sectors of the American economy. First one should understand the assumptions that lie behind the theory of deficit finance as well as some statistical facts about the history of deficits and surpluses and the business cycle in the US.
First of all, whenever the government spends on programs or transfer payments more than it takes in in revenues the government will run a deficit. This deficit can be measured and financed in a variety of ways and it can be spent on a variety of programs or tax reductions.In terms of measurement it seems sensible to view expenditures on infrastructure as long term investments and treat them accordingly in the public accounts.

In addition most economists who advocate deficit finance to counter an economic downturn assume that for every dollar spent directly there will be at least another dollar or possibly $.66 of additional spending that will be induced by the original expenditure. Some economists would suggest that the multiplier would be larger others that it would be smaller.

This multiplier is bound up with what is called the Keynesian or more accurately Kahnian multiplier(named after the brilliant British Jewish economist R.F.Kahn who was a very close colleague of Keynes at Cambridge , one of the first economists to develop the idea and who made a major contribution to the General Theory.)

The way that the multiplier works is derived from the mathematical formula for summing up the total of a geometric series. For example let us assume that the series is 1+ v + v(v) + v(v)(v) +….= 1/(1-v) if -1 is less than v and v is less than 1.
(see Robert Barro, Macroeconomics, p.508)

The formula for the multiplier is then 1/1-mpc where mpc is the marginal propensity to consume equivalent to v in the above geometric progression.

In other words the percentage of the last additional dollar you receive that you spend. It also matters where you spend the money. If you spend it on goods and services produced in the country the multiplier is much larger than on goods and services produced elsewhere but sold in the country by a local sales staff. These leakages plus monies received which are not spent but either saved or hoarded are subtractions from the overall multiplier impact.

So lets begin with some statistical facts. The current American deficit is about 1.7 % of the US GDP. The GDP is 13.97 trillion dollars( as of the end of the third quarter 2007) so the deficit is around 244 billion dollars. A 1 % stimulus package would increase the deficit by a further 140 billion, a 2 % package by 280 billion a 3 % package by 420 billion. During the war years 1943, 44 and 45 the deficit rose above 15% of the GDP peaking at over 31 % in 1943. A 3-5 % deficit is very modest indeed in comparison.

If we assumed a multiplier effect of secondary increases in expenditures traceable to the initial injection of 140 billion and a multiplier of 1.5(not all economists would agree that it would be that large, others might suggest it would be larger) the total impact of a one time injection would be $210 billion .

Total accumulated gross Federal debt of 9196.5 billion is currently(the net product of previous deficits and surpluses) 65.7 % of the GDP. During the war years 1942-45 this ratio reached 119 %of the GDP.

To finance this without raising interest rates the Fed Reserve can either buy bonds originally issued by the Treasury but currently held by individuals or financial houses for some of this additional amount thereby creating high powered money that partly offsets the sale of bonds by the Treasury which finances the deficit and then sell some of these bonds to the general community of investors or it can simply expand the money stock. If it does the former however and the financial markets resist the interest rate that the bonds are offered at, the Fed will have to purchase an equivalent further offsetting amount and or inject further high powered money into the system.Later as the economy recovers it can and should withdraw some of the stimulus by selling these bonds back to the investing markets.

(For a thorough discussion of these techniques and the operations of the Fed and the treasury see the work of Robert Eisner , a former president of the American Economics Association and late Professor of Economics at Northwestern University in Chicago where he taught macroeconomics. I had the pleasure of discussing these themes with Eisner in person in Montreal when I brought him to lecture to my students in 1988. Robert Eisner, How Real is the Federal Deficit, pp.131-135.New York;The Free Press, 1986. Eisner’s research and his book was supported by research grants from the National Science Foundation.)

The point is that true Keynesian stimulus involves the scissors effect of a fiscal stimulus financed by by a supportive monetary policy. This is why monetarists like Karl Brunner insist that Keynesianism would only work with the creation of high powered money. But that is a debate for another time.

In the current environment in the financial markets I would think that these bonds will be viewed as highly desirable investments. The more that the Fed purchases the bonds the greater the stimulus however. Strict monetarists will argue that this will also lead to higher inflation in the medium to long run.

Keynesians would not necessarily agree arguing that with a slowing economy and higher unemployment the stimulus will increase largely output rather than prices. Later as unemployment drops some of the stimulus will be transferred to the price side of (P.O i.e.average prices times units of output) at which time the Fed can sell more of the debt to the market.

Once the money is spent on tax rebates, infrastructure projects, food stamps and environmental projects it is received as income by both taxpayers and employees who are hired to work in these projects or who are hired by the private sector who because of the stimulus project have experienced a greater demand for their products or services and have changed their mood from pessimistic contraction to optimistic expansion.

The additional money injected circulates in the economy. Much of it depending on the average marginal propensity to consume will be spent again and recirculate throughout the economy changing expectations from pessimistic ones to optimistic ones.

Investments once postponed will be considered again and a number of them undertaken. As unemployment drops the economy moves from recession to steady growth again.The newly employed both spend their money on goods and service and pay taxes to government. Some of what was spent, but not all, returns to the Federal Government in new tax revenues. As the economy grows larger the debt to GDP ratio provided the interest rates are kept lower than the growth rate in the economy begins to fall.

A little later the actual deficit may well shrink as well.Excess savings that would have subtracted from total aggregate demand because they could not find suitable safe and attractive investment opportunities will now be effectively channelled into attractive investment opportunities.

The stock market beset by uncertainty and insecurity will also begin to experience bullish sentiments. The unemployment rates will drop perhaps by as much as 1 % point as over a million and a half new jobs
are added to the labour force. If the jobs pay on average 40-50,000 dollars the federal and state governments will reap substantial additional tax revenues to help reduce the cost of the stimulus package.

The stimulus package will have done its work.

What might go wrong ? Well the multiplier might be smaller because of leakages to foreign imports. Recipients of the tax rebates might decide not to spend their rebates trying to save them instead, less likely if the rebates disproportionately target moderate and low income people. The Fed may cause interest rates to rise by trying finance the deficit too quickly in the bond markets.

Financial journalist might write influential articles that convince people that the stimulus package won’t work and that interest rates will rise and inflation will result.

Here the collective wisdom of the public which is somewhat more Keynesian than the financial journalists will cancel out most of this kind of negative journalism.

Keynesian rational expectations rather than monetarist ones should prevail !

But for the moment if the members of Congress seize the day and the President co-operates and the package is large enough to do the job, the US can once again demonstrate western leadership in economic policy making that will have far reaching positive consequences.

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Monetized government Debt as a percentage of the broadly defined money supply and the rate of inflation Canada 1950 to 1989

I am reproducing the following table of data because of its importance in showing that there is no necessary correlation between the percentage of debt that is monetized as a proportion of the broadly defined money stock
and the rate of inflation, contrary to the conventional wisdom. There were years when the central bank held a much smaller proportion of the debt in relation to the money stock and the rate of inflation was higher and there were years when the proportion monetized was much greater and the rate of inflation was very low. My motivation in researching this relationship was wanting to show that Keynesian deficits would not necessarily result in interest rate crowding out as many monetarists claimed and to ensure that this would not happen the central bank had the power and the policy room to keep rates low to allow fiscal stimulus to do its work in reducing unemployment. I first wrote about the issue in 1984 and published the table in the beginning of the 1990s. Our recent experience in the U.S. with a large rise in the percentage of the debt that is monetized through quantitative easing and the stability of low inflation should reinforce the argument that there is no necessary connection provided the level of monetization is within certain limits. Inflation is not a black box experience. Rather it like unemployment is a complex phenomenon in which the structure of markets, the degree of oligopoly power and the strength of trade union wage negotiating power all must be factored in.

Table 3:
Monetized government Debt as a percentage of the broadly defined money supply and the rate of inflation Canada 1950 to 1989.
Rate of inflation
Source: Calculated from the Bank of Canada Monthly Review and the Canadian Department of Finance Quarterly and Annual reviews 1950 to 1989. The table first appears in Harold Chorney ‘’A Regional Approach to Monetary and Fiscal Policy’’ in J.McCrorie and M.Macdonald, The constitutional future of the Prairie and Atlantic Regions of Canada, Canadian Plains Research Centre, University of Regina, 1992. It is also discussed and reproduced in Harold Chorney ‘Debts, Deficits and Full Employment’’ in D.Drache and R.Boyer, States against Markets:The Limits of Globalization, Routledge, 1996  and the approach as a policy tool in The Deficit:Hysteria and the Current Crisis, The Canadian Centre for Policy Alternatives, Ottawa: 1984, which is largely reproduced in my collection of essays with P.Hansen, Toward A Humanist Political Economy, Montréal&N.Y. Black Rose Press,1992.
My colleagues the late John Hotson of Waterloo and Mario Seccareccia of the Université d’Ottawa also co-authored one of the publications, a pamphlet which sought to popularize the argument entitled The Deficit Made Me Do It.
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Even IMF believes in debt financed public infrastructure: at current low interest rates multiplier may be 3

According to a commentary by Larry Summers in today’s Financial Times the IMF has pronounced itself finally in favour of major public infrastructure investment financed not by tax increases but by medium and long term borrowing. The current low interests that prevail make it possible for investments in public infrastructure to be financed by the issuance of public debt and more than pay for themselves. In fact, the IMF is arguing that for a given dollar of public investment financed in this way there will be close to a threefold increase in output. That is a multiplier of nearly 3 ! This comes as no surprise to Keynesians like myself who have been arguing precisely this point for decades. But it may well come as a shock to the neo-cons and fiscal conservatives who fill the front ranks of finance ministries the world over including here in Québec. Austerity is quite simply the wrong approach to solving our current economic problem. I have stated it many times.Other Keynesians and post Keynesians have argued it for years. Paul Krugman and Joseph Stiglitz originally cautious about deficits have written about it. Larry Summers has come on board.President Obama supported the position and the U.S. economy benefitted. And lo and behold the anti deficit IMF now argues the same point. Its about time the political establishment embraced this.

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Keynesian stimulus policies bear fruit:US unemployment drops to 5.9% lowest since 2008

The unemployment rate dropped to 5.9 % in September the lowest rate since 2008.The broadly defined definition of unemployment which includes discouraged workers who have dropped out of labour markets also fell to 11.8 %. This is very good news and if it continues over the next few months the unemployment rate should begin approaching 5 %. Most of the new jobs were in the retail service sector but education and health care also reported gains.So despite all the criticism of the Obama stimulus including the accurate critique that it should have been larger Obama and the former and current heads of the Federal reserve deserve a lot of credit for bucking the tide of anti-Keynesian dogma and carrying through with a joint program of an accommodating monetary policy including quantitative easing and a substantial fiscal stimulus, albeit one that could and should have been larger. Just contrast the American situation with the mess that austerity and tight money has caused in Europe.

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Ed Balls embraces fiscal austerity at Labour Party conference: A Major error

The shadow British Chancellor Ed Balls speaking at the Labour party conference has foolishly embraced the fiscal conservative principle of no new deficit financed funding for education or social investment or infrastructure when and if Labour is in office. This despite the fact that the rise in indebtedness is almost entirely due to the crash brought about by the private banking system and deregulation and rise in unemployment that neo-con governments had introduced over the previous several decades.Check out these historical charts on the debt to GDP in the UK.the debt to GDP ratio and the deficit The debt to GDP ratio is nowhere near its historical maximum of over 250 % as the charts illustrate.Furthermore almost 70 % of the UK debt is held by domestic UK investors including the Bank of England .(See in particular the last chart on the page which plots the ratio of public sector debt to the GNP over the period 1692 to the present) The current level of close to 80 % is in fact moderately low when viewed over the history of British finance since 1692. It is currently elevated only because of the crash and crisis and its quite foolish and unnecessary to pledge no debt financed spending on capital account when there is such a large need for it in Britain and the neglect of it has helped fuel right wing political movements like UKIP and nationalist movements like the SNP. I t may seem appealing as a defensive measure against Tory charges of financial lack of discipline but Labour ought to educate their electorate about how damaging austerity has been, what the alternatives are and how to repair the damage. Instead Balls has boxed Labour in with his pledge. Too bad.

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United Kingdom breathes sigh of relief:Scotland votes no 55%to 45% yes,Devolution on the way

In a hard fought exciting Scottish referendum contest with an overall turnout of 84.6% the No forces have won a clear victory 55.3 % to 44.7% Yes. The final numbers were only completely counted in the early hours of the morning in Scotland but they revealed a clear cut victory for the no side. The no side received 2,001,926 votes compared to the 1,617,989 votes for the yes.Of the 32 councils reporting results the Yes side won only four of them and came very close in one other, Inverclyde known for its ship building industry. The four were Glasgow turnout 75% where the Yes won with 53.5 % of the vote 194,779 votes to the no 169,347 votes,46.5 %; Dundee turnout 78.8% yes 53,620 57.3% no 39,880 42.7 %; North Lanarkshire 84.4% turnout Yes 51.1% 115,783, no 48.9% 110,922 and West Dunbartonshire turnout 87.9% yes 54 % 33,720 and no 46 % 28,776. In most of the other 27 areas the No side won by relatively large margins. Unemployment was higher in the areas which voted yes.

However, the yes side did well enough with 44.7 % of the vote to bring about what looks like will be major changes in terms of additional powers given to the Scottish parliament and consequently a major debate about devolution of comparable powers to Northern Ireland and Wales and perhaps the establishment of an English Assembly and the principle of England’s voters representatives only voting on English issues and policies just as only Scottish MSPs will vote on Scottish issues and similarly for Wales and Northern Ireland. This will be a lively and difficult debate for the UK as a whole with the political parties disagreeing about the character and extent of devolution. For example Labour might well be reluctant to accept totally the principle that Scottish MPs at Westminister not be entitled to vote on devolved issues like health care and education because so many of their MPs come from Scotland and they might lack a majority among English MPs even if they become the Government of the UK after the next election.

At the other end of the spectrum the anti EU party UKIP is a strong advocate of the principle that only English elected MPs should vote on devolved policy areas.

So the road ahead will have many twists and turns as the United Kingdom evolves from a quasi unitary state to a close to federal state. As a Canadian observer I offer my best sentiments and wishes for success for the difficult debates and issues to come. There is much to be learned about the benefits of flexible federalism and sensitivity to regional minorities for healthy polities. We can learn much from each other in this increasingly democratic and integrated world.

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Scotland the brave: the road to the referendum

The spectre of Scotland voting yes to become independent of Great Britain in ten days haunts the British press and Britain’s political class. Like its cousin the Québec independence movement the Scotland referendum campaign has tightened into an apparently close horse race as the referendum day draws near. Many Canadians who follow politics and particularly Québecers are following this referendum closely. Many Canadians have Scottish or British roots and families. Many of us are very familiar with the excitement or dread that this sort of referendum can produce.The debate in Britain revolves around the traditional issues that bedevil these affairs. What are the terms on which Scotland would separate from its three hundred year old partner? Would Scotland have its own central bank and currency? The Scottish independence movement says it intends to negotiate a currency union with Britain but the Government in London insists that it won’t agree to a currency union. How would the national debt be divided between the newly recreated country of Scotland and its former partner? What role do ideological differences play in the debate? Can we make better sense of the debate by viewing it as a clash between neo-liberal politics and democratic socialist or social democratic politics? What would happen to Wales, England and Northern ireland if Scotland left? If Scotland votes narrowly no will this close call lead to federalist reform in Great Britain ? How much capital flight from Scotland will occur in the final days of the referendum campaign ? What would the consequences be of a yes vote in Scotland in Spain with its Catalan separatists, in Belgium, in France, in Québec ?

Paul Krugman has written a piece in the NYT in which he argues that Canada is an independent Scottish proxy in North America, a successful much smaller independent country from the U.S. with its own central bank and currency and more left of centre in social and economic policy. So if Scotland wishes the same status it needs to plan for its own currency and central bank something its nationalist leadership has insisted won’t happen. But Canada never broke away from the US. rather it was the US that broke away from British North America a revolution that Canada refused to join. So the analogy is not a good one.Furthermore Canada like the U.S is a continental country with vast resources and a population that is over 35 million people.But Krugman is right to argue the importance of having ones own currency and central bank. Some years ago when the Canadian doller was trading in the low 60cents US band a number of misguided Canadian economists speculated on the wisdom of abandoning our currency in exchange for a new shared currency with the U.S. That would have been a very bad idea and looks particularly foolish now that the currency has traded at above par since then and in the 90cent range recently. I wish the Scots and Britons well in the coming tense days.

Personally I think a respectful rejection of the nationalist side is a better outcome for both Scotland and Great Britain. Creative federalism and devolution can solve most of the complaints. A renewed commitment to full employment and greater support for the NHS would also help considerably. Whatever the outcome from the wilds of the Grampian mountains to the beauty of the south Downs from the delights of Edinburgh to the grandeur of London Britain and Scotland will remain a diverse land rich in history, culture and natural beauty.

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