To find our borrowing limit, let’s take the
banker’s viewpoint. A cautious banker will grant a
mortgage if the home-buyer has a good credit rating and an
income that can service the loan. So, one’s
creditworthiness depends upon one’s history and income.
The same criteria apply to nations. Our bond-holders will
be patient if our nation is thriving as judged by its DR
decline and its GDP growth. These determines our tax
revenue, liquidity, and credit. With strong enough GDP
growth, the DR can decline, even with modest annual budget
deficits. For that reason, the DR is much more important
than the ND.
In classical (not Keynesian) economics, this criteria is
recognized in undergraduate courses as the "Golden Rule":
As long as the long-term, inflation-adjusted
Treasury bond interest rate is lower than the
long-term, inflation-adjusted GDP growth rate,
the government should borrow as much money as
it can borrow and spend as much of it as it
can efficiently spend on infrastructure.
At present, the long-term, inflation-adjusted Treasury bond
interest rate is well under 2%. Since the long-term,
inflation-adjusted GDP growth rate is over 3%, there is at
least 1% of leeway for borrowing. Yet conservatives are
calling for a balanced budget! Their ignorance of basic
(not Keynsian!) economics is astounding.
Keynesian and Lernerian economics agrees with the "Golden
Rule" and goes a step beyond: the multiplier. Rather than
try to define the term, we will use an analogy.
The Ripple Effect
If you drop a stone into a placid pool, there is first a
splash and then a series of concentric circular waves
rippling outward from the point of impact, with the height
of each wave diminishing with distance until it finally
disappears. The number of waves and their height depend
only on the mass of the stone and the height of the drop.
In the language of physics, the potential energy of the
stone is converted into the kinetic energy of the waves
plus some heat energy due to friction.
If you gradually empty a sack full of stones of various
size into the pool over a period of time, the laws of
physics still applies to each stone, but the disturbance on
the surface is more diffused. The ripples are not as
obvious but the energy balance still holds.
Now think of a stimulus acting as a sack of stones, a
stream of federal government checks of different values
entering the economy over a period of time. The total
effect of the stimulus is equal to the sum of the
individual effects of each check. But what is the effect
of each check?
When government makes a purchase from a vendor, it is a
retail purchase adding to the GDP, akin to a splash of a
stone as it hits the water. And the check also has a ripple
effect as the vendor uses the funds from the check to write
other checks to pay other vendors and employees, as well as
to provide for her own salary and/or dividend. These
"ripples" also add to the GDP.
The chain of spending from vendor to vendor to vendor,
etc., has no effect upon the GDP. But when a vendor pays
employees and herself as individuals, they become consumers
who either save (about 10%) or spend the rest (about 90%)
of their disposable (after-tax) income. All of the consumer
retail spending adds to the GDP.
You can think of the tax payments (about 30% of individual
gross income) as similar to the friction that causes the
potential energy of the stone to generate heat instead of
waves. And you can think of the checks that go to
individuals as the waves that ripple through the economy,
individual to vendor to individual to vendor, etc., in
diminishing amounts.
The rippling through the economy of the original government
check is inexorable. The money goes to vendors and
individuals who can save little of it. There is little or
no extraneous effect upon the process. The total addition
to the GDP is determined by the mechanics of the economy -
how individual spend and how vendors "do business" - and
not by extraneous events.
As the rippling through the economy of each government
check eventually diminishes to zero, the total addition of
the government check to the GDP is the value of the check
plus the additional consumer purchases. The ratio of this
total GDP value to the value of the government check is the
value of the "multiplier". The value of the multiplier is
determined only by the mechanics of the economy, not by
extraneous events.
The effect of a stimulus upon the economy is the sum of
the effect of each of its checks distributed over time.
Thus, a stimulus S and a multiplier M will cause a total
GDP growth equal to M × S over a period of time,
regardless of extraneous events.
Numeric Example
As an example: (using mid-year 2011 approximate results
as reported by usdebtclock.org)
ND: $14.5T
GDP: $14.8T
DR: 97.97%
If a stimulus (S) generated its value in total consumer
spending (TCS), the value of the ratio TCS / S would be 1.0
and the value of the multiplier would be
M
= (S + TCS) / S
= 1.0 + (TCS /S)
= 1.0 + 1.0
= 2.0
With the multiplier M ≈ 2.0 and a 5-year stimulus S = $1T,
then average GDP growth,
ΔGDP,
= M × S / 5
≈ 2.0 × $1T / 5
≈ $0.4T
Since GDP growth increases tax revenue (TR) and, relative
to GDP, our tax burden (for all levels of government),
TB
≈ 30%,
therefore, our 5-year tax revenue growth,
ΔTR,
= ΔGDP × TB × 5
≈ $0.4T × 0.3 × 5
≈ $0.6T
And
the new ND would be
$14.5T (current ND)
+ $ 1.0T (stimulus)
- $ 0.6T (tax revenue growth)
≈ $14.9T (new ND)
And
the new GDP would be
$14.8T (current GDP)
+$ 0.4T (GDP growth)
≈ $15.2T (new GDP)
The new DR would be:
$14.9T / $15.2T
≈ 98.02%, which is only 0.02% more than the current DR.
Although $0.4T was added to the ND, the DR was hardly affected.
For that reason, GDP growth is more important than the value
of the ND or the annual budget deficit.
Q. What is the limit
to borrowing and deficit spending
during a recession?
A. Borrowing is justified when we expect
that the deficit spending will generate
enough consumer spending (and GDP)
to reduce the DR.
Remarks on the Multiplier
Please note: Because
(1) at 1% interest rate on debt due to the recession,
the annual interest expense due to the stimulus is
about 3% of the corresponding tax revenue gain and
(2) to simplify the explanation,
therefore,
we have ignored the added debt interest expense in
the calculation above and shall continue to ignore
it throughout this course.
In the calculation above, we hypothesized that $1T
stimulus would stimulate $1T of consumer spending.
Effectively, the stimulus was multiplied by 2.0 to
create the total consumer spending.
The multiplier is a controversial subject because of:
1. The difficulty of determining its theoretical value which
is dependent only upon the actual spending habits of
consumers and producers. We will devote two lectures to
finding the theoretical value of the multiplier.
2. The difficulty of isolating the effect of a stimulus
occurring in a dynamic economy also affected by a multitude
of other major factors: war and other disasters, declines
in revenue due to unemployment, trade deficits, etc.
In a later lecture, we will evaluate the 2009 stimulus
(ARRA) but it must be understood that the value of the
multiplier cannot be judged simply by a post-stimulus view
of the economy. The signal cannot be separated from the
noise if it is weaker than the noise. It is only when the
stimulus overwhelms other factors (e.g, WW II spending)
that the effect is obvious.
Whatever the dynamic factors may be, a stimulus will
superimpose itself upon the economy and have an effect
proportional to the true value of of the multiplier. That
is why we must understand the theory.
Proceed to: Lecture 7
DEFINING THE MULTIPLIER
Thanks for your interest.
Marvin Sussman, retired engineer
If you don’t like the world as it is, change it this way!:1. Depress the Shift Key,
sweep the cursor over the following URL,
click, copy, and paste it on email to friends,
and ask them to do the same:
Keynesian Economics 101
The ONLY way out of this mess
Free lectures on-line:
KeynesForum.blogspot.com2. To print and distribute single-sheet “invitations”
to this site, click here
and ask your friends to do the same.
3. To donate toward advertising this website,
click the yellow “Donate” button below.
You will be asked for your PayPal account password.
If you don't have a PayPal account,
you will need a credit card.
No comments:
Post a Comment