The Illogic of the Keynes Multiplier - 1

John:  Here are my restaurant bills for the last 5 years.
Mike:  Another discovery?

John:  My restaurant spending is always close to 10% of my income. That is, my income is 10 times my restaurant spending. So now I know a fun way to increase my income.
Mike:  I have to hear this.

John:  I will increase my restaurant spending by $2,000, and I will enjoy every minute of it. Then, my income will go up by about $20,000. That is what the chart says.
Mike:  You're nuts.
John:  No, I'm Keynes.

Reading Notes:  If you are familiar with the Keynes Multiplier or are impatient, jump directly to the section An Unreal InterpretationA link there will return.. Then read Equations and CausationA link there will return.. Then read the rest, of course.

The Keynes Multiplier Is Important

The Keynes Multiplier is probably the most important equation in history, despite using only introductory algebra. It has changed the world. It supports the big spending (fiscal, borrow and spend) policies of the United States government and the European Union.

  Total Income = 5 * (Investment + Govt Spending) 

It supports the belief that increased government spending (stimulus) produces more wealth than the money spentSpending decreases your wealth. It is only what you get in return, if anything, which increases it., at least when there are people out of work or economic growth is slow. If government spending increases total wealth, then huge spending is always good.

The famous economist John Maynard KeynesSee a few criticisms of Keynes at The Political Dictionary (1883-1946) (M)See Wikipedia for his life story. proposed ending the Great Depression by having the government spend lots of money, by first taxing, borrowing, or printing it. Politicians heartily agree, spending to fix every problem in good times and bad. This doesn't seem to help much, so their plan is to keep spending until it does.

Something Is Wrong

Steven E. LandsburgMore about him  is a Professor of Economics at the University of Rochester. He has two excellent posts at his blog TheBigQuestions.com exploring an amazing defect in the logic used to explain the Keynes Multiplier.

•  The Landsburg Multiplier
  -   How to Make Everyone RichSee his post.
•  Comments on the Multiplier postSee his post.

Landsburg derives his multiplier by using the same logic that Keynesian economists use to derive the Keynes Multiplier. He analyzes the relation of national income to his own income.

The Keynes Multiplier is about spending. The Landsburg Multiplier is about income. Both derivations use the same procedures, math, and logic.

Landsburg shows:

  Total Income = 100 million * Landsburg's Income 

So, Landsburg wryly suggests that people send him all the extra dollars they have, this will add to his income, and $100 million of added production will appear in the economy for each dollar sent to him. This will make us all rich.

Landsburg says correctly that this is an absurd result. This derivation of the Landsburg Multiplier must be wrong, and so the derivation of the Keynes Multiplier must be wrong.

Where is the error? It is puzzling that the facts are true and the math is simple. Landsburg suggests that the derivations may be wrong because they do not allow for the changes in consumer spending which likely follow changes in government spending. Equations describing economic behavior are unlikely to remain valid after a change in economic policy.

Economics is supposed to guide policy. This general criticism is that any economic formula might not be true after changes in economic policy. The formula might not predict results because the participants change their actions in response to the policy that the formula recommends.

This applies to all formulas and derivations. They represent what you think is true at some time. Rarely does everything interact in the same way after a significant change. Whatever the formula, you must verify the results in reality.

That criticism is good and often overlooked. But, it can't be what is wrong with the Multiplier. We get impossible results from the logic alone.

The truth is that the Multiplier is a wildly unrealistic result derived from an illogical argument. That is bad enough in a high school paper. It is alarming for a false insight which is used to mismanage societies.

An irony. It is harder to unravel and identify the errors in a simple argument than in a complex one. Those errors contain subtle defects, changes in meaning, and illogical conclusions. Once a person believes a simple argument, his tendency is to reject criticism, because it is hard to stop believing something he thought was obvious.

Reversal of Cause and Effect ...Click for the rest of this post.

Overview

The Keynes Multiplier is the statement that the total income of the United States (or any country) is about five timesThe actual claim varies according to a broad estimate of consumer spending. This is an omen that something is not right. the amount of money invested in businesses and spent by government.

  Total Income (GDP) = 5 * (Investment + Govt Spending) 

GDP is Gross Domestic Product, the total production of goods and services in the US in a year or other specified time interval. Income is the flip side of production. Each person's income is the value he receives from his production. Someone receives income for every bit of production.

Keynesian economists see this as a fundamental economic truth first discovered by Keynes. They continue to the Keynes Conclusion that the total income of the country increases by 5 times any increase in government spending, or some similar multiplier.

They could conclude the same thing about increases in Investment, but politicians and Keynesian economists don't understand investment.

That increased income is supposed to appear as increased production, namely increased real wealth.

The Keynes Multiplier presented here is derived from reasonable assumptions and is only complex enough to make it seem significant. The 7th grade mathematics is simple and correct. Yet:

• The derivation presents a reversal of cause and effect.
• The conclusion presents a fact about the equations as if it is a fact about reality.

These fatal errors hide in a few simple equations and a seemingly obvious conclusion. Like a magician pulling a rabbit from his hat, everything seems ordinary until the rabbit appears. You may think that I am exaggerating, but bear with me.

Landsburg reports that this derivation is widely taught. For example, it is presented in the popular textbook "Macroeconomics" by Robin Wells and Paul Krugman, and in a textbook by Paul Samuelson. Those noted economists apply an equation to economic policy without checking on reality, and they have made fundamental errors in logic.

How could Keynesian economists with advanced degrees and world acclaim present this idiotic derivation and conclusion about what they have studied in great detail? It is a puzzle.

Landsburg notes a subtlety. Defenders of the conclusion might agree that the Landsburg Multiplier is absurd, that we can't trust the reasoning which produced it, and so we can't trust that same reasoning to produce the Keynes Multiplier. But, the conclusion might be shown in some other way.

The conclusion confuses cause and effect. It is no wonder that it can be derived from a confused argument.

This Derivation of the Keynes Multiplier

We first allocate All Production into three categories depending on who buys it: Household Spending (Consumption), Business Spending (Investment), or Government Spending (Govt). The flip side of production is income; all production is someone's income, so we can write All Income (Y, GDP) for All Production.

K1:   All Income  =  Household + Business + Govt 

K2:   Household  =  0.8 * All Income 

K2 is the estimate that 80% of all production goes to households as Consumption spending. This estimate might be incorrect, but this doesn't change the logic and general conclusion. It is plausible.

This is somewhat different from Keynes' Propensity to ConsumeSee also Economics Exposed.com.. That is the fraction
  (consumption spending) / (disposable income)
for any level of disposable income.

K3:   Business + Govt  =  0.2 * All Income 

Business and government purchase the remaining 20% of production.

K4:   All Income  =  5 * (Business + Govt) 

Switch the sides in K3, then multiply each side by 5. The result is K4, the Keynes Multiplier.

K5:   Increased All Income  =  5 * Increased Govt 

This is the Keynes Conclusion. Supposedly, if we increase Govt SpendingPoliticians, report to your tax and spend stations!, All Income will go up by 5 times that increase, and the additional income (GDP) will heal the economy.

What is the mechanism that increases production by a factor of 5? Amazingly, that detail is not in the equations. A statistical observation is supposedly telling us that spending $1 creates $5 of new production.

If we do the above using the Household fraction (K2), we get a spending multiplier of 1.25 for any increase in Household Spending. What is it about Household Spending in reality that gives it a different multiplier than Government Spending or Business Spending? It seems that this puzzle has remained unexplained.

Equations and Causation

Equations are convenient for relating quantities. They can "model" known or proposed relationships between physical things in the real world. But, equations don't care about how they are interpreted or about cause and effect. That is the responsibility of the user. For example:

Economist Bill studies how people react to rain. He observes:

  Raining  =  Many people wear raincoats 

Bill reads this as "When it rains, many people wear raincoats", and the reverse is also true "When many people wear raincoats, it is raining". Bill has observed this for many years without exception. It is an established result in the physical world.

Bill knows that rain causes people to wear raincoats and that wearing raincoats does not causeThis has been extensively studied and verified. it to rain. The mechanisms of the physical world are not part of the equation.

Bill's inexperienced assistant John looks at the equation and says "Now I know how to make it rain. If I can get more people to wear raincoats, then it will very probably rain. If I change the right side of the equation, that will change the left side. That is what '=' means."

Bill explains to John. "If you hear that many people are wearing raincoats, then in all of my experience it is raining. If you hear that it is raining, then in all of my experience many people are wearing raincoats. The equation expresses what we observe in nature, but it doesn't say anything about one thing causing the other. You have to look at the physical world to see what is going on."

An equation can accurately describe the observed relationship between quantities in the physical world. Still, that says nothing about what will happen if you try to physically change the system that you hope is represented by the equation. It is the difference between observing a system of many parts and changing one of those parts. You can't know from your past observations what that system will do in its changed form. You can't know the real cause and effect unless you specifically determine that by examining the physical world.

John understands. He can't conclude from the equation that raincoats cause rain. But, clearly rain causes raincoats.

Maybe simulated rain also causes raincoats. He uses a water hose to sprinkle the public, just like rain. But, they don't put on raincoats. Instead, they punch him in the face.

What is it about real rain, but not simulated rain, which causes many people to wear raincoats?

Life is complicated. Even if you respect cause and effect, you cannot know how a change will affect reality unless you have studied the physical details and have shown by observation that the changes do what you predict.

This is especially true of economics, which is the study of amazing complexity, namely of people, their interactions, and motivations. You can record what people do. This may suggest that changing something will have a desired effect. In reality, you don't know unless you study the change and the effect.

The simulated rain example may seem contrived. John was punched for reasons completely apart from the quality of the sprinkled water. That is the point. There is immense complexity in simulating economic conditions. The participants will see the manipulation, include that information into their response, and may act in a different way than they did before.

Mathematics is only an aid to thinking. It represents insights and quantities in a way which can be easily written and combined. The results can suggest more things to think about and investigate.

Physics gives mathematics a reputation for predicting the future. The universe seems to follow mathematical results, but it is actually mathematics which has been constructed to model the universeSee also About.com - The role of mathematics in physics.

Physicists know that their mathematics is almost always a simplified model of reality. They are dismayed but not surprised to find that an equation makes bad predictions. They always compare their expectations to reality to correct inevitable mistakes. When in doubt, they distrust the math, not reality.

The inspiring particle physicist Richard Feynman (1918-1988) fought for open, transparent science. He wrote:Cargo Cult Science, from the 1974 Caltech commencement address.

When someone says, "Science teaches such and such", he is using the word incorrectly. Science doesn’t teach anything; experience teaches it. You should ask, "How does science show it?"

How did the scientists find out? How? What? Where? It should not be "science has shown". And, you have as much right as anyone else, upon hearing about the experiments and after hearing all the evidence, to judge whether a sensible conclusion has been arrived at.

Airplanes are designed with well understood equations representing tested physical principles. Still, every airplane design is thoroughly tested for flight worthiness. Mathematics is a sophisticated guide to building and testing, but assumptions and math may not predict reality.

Which airplane would you like to fly on? One has been designed by teams of engineers using super-computers, but never tested. The other has been built from rough estimates and is thoroughly tested.

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An Unreal Interpretation

We will look at the derivation again and keep track of cause and effect. To save space and thought, BusGovt means Business + Government Spending, and All is All Income

K1:	↔	All  =  Household + BusGovt
K2:	←	Household  =  0.8 * All
K3:	←	BusGovt    =  0.2 * All
K4:	→	All  =  5 * BusGovt
K5:	→	Increased All  =  5 * Increased BusGovt

This derivation describes a relationship between numeric values. It doesn't care about cause and effect, and it may not represent reality even if the reader thinks that some or all of the relationships are realistic. Math models may do a good job of representing reality in some ways, and be wildly wrong in others.

Physicists know this about mathematics. It seems that Keynesian economists do not, or choose to ignore it. The following facts are so basic that it is embarrassing to explain them.

The red arrows above are a reminder of what we see as cause and effect. When I say "the equation tells us", remember that we are getting back in some form just what was put in.

( Click on the K1 .. K5 labels below to pop up the above equation being explained. )

K1  ↔  All  =  Household + BusGovt  is an accounting identity. The "=" tells us that these amounts always add up. The double arrow says that I expect both sides to be equal in reality, even if I meddle. If I increase my total spending by $100 to buy donuts, production of donuts also goes up by $100 (after some inventory fluctuations), and others get $100 more in income. K1 balances approximately even if I meddle with the physical world.

K2  ←  Household  =  0.8 * All  says that Household Spending is 80% of All Income (All Spending). We might be thinking that it is approximately 80%, but we have specified that it is exactly 80%.

The red arrow points to the left. It reminds us that we think Household Spending is a result of total spending (total production). If we can increase total production through better government policy, we expect that Household Spending will get 80% of that production. We think Household spending is a part of total production.

Still, all of this would have to be checked against reality. Increasing total production might not increase the part going to households. For example, building tanks for war does not result in households receiving 80% of the tanks. If households buy 80 more donuts, they get just those donuts. There is no reason to believe that 100 donuts are produced so that households receive 80 and BusGovt receives 20.

K3  ←  BusGovt    =  0.2 * All  is all spending other than Household. The proper interpretation is:

The red arrow for K3 points to the left. It reminds us that we start with All Income produced in unspecified ways. We know that production supports investment, taxes, and government borrowing. Somehow, that averages out to BusGovt getting 20% of production. Our knowledge of physical processes makes the cause and effect in K3 believable.

K3 is a summary of past observations. The economy is a natural system resulting from the complex interplay of people and politics. It has produced values approximately satisfying K3.

If we are interested in a particular value of BusGovt, then we can use the model to calculate the naturally occurring value of All Income that would produce that value of BusGovt.

If we meddle and change that natural system by redirecting spending, K3 is only a weak suggestion about how the economy will change. Only direct observation could tell us that.

K4  →  All  =  5 * BusGovt  is a restatement of K3, having the same meaning in all respects. The cause and effect arrow now points to the right. We still believe that All Income determines (causes) BusGovt.

But, the presentation of K4 suggests that we start with BusGovt to calculate All Income. The strong suggestion is to reverse cause and effect, to accept that somehow BusGovt causes All Income.

We must decide if that possibility has physical meaning. It is illogical to believe that the equation alone is enough to predict that BusGovt Spending causes 5 times its value in Income. It is laughable that this interpretation rests on no physical processes whatsoever.

K5  →  Increased All Income  =  5 * Increased BusGovt  is the conclusion repeated everywhere. It reverses cause and effect, and it assumes that we can predict the results of changing a natural system.

The cause and effect we specified starts with Increased All Income to produce a 20% increase in BusGovt, enough to balance the equation. That is truly boring.

It is much more exciting to accept a reversal of cause and effect merely because the usual computational flow of K4 suggests it. It is illogical to believe that the physical world cares about the order of the terms in K4 and the resulting K5.

Say that I increase BusGovt Spending by $1 billion. By what possible physical mechanism is the universe going to respond to this by increasing All Income just so K5 will balance? What has caused learned economists to interpret this model in this unphysical way?

Many cars have a dial odometer. A red pointer moves like the hand of a clock, pointing to the speed of the car. The odometer always shows the correct speed if you limit yourself to observing the odometer and verifying the speed. A Keynesian observes that the car is traveling 30 miles per hour and takes action. He grabs the red arrow and pulls it to the right, believing this will speed up the car. That is what the equations say to him.

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The Undead

The analysis above is enough to discredit this simple derivation of the Keynes Multiplier. Anyone using this derivation should be ashamed. But, as Landsburg points out, a bad derivation doesn't prove that the result is wrong, only that it remains unproven.

There is another more complicated derivation more closely associated with Keynes. I will pick that one apart in another post.

That complicated derivation must also be wrong. It has all of the characteristics of the derivation above, but with flashier mathematics. It is also an accounting derivation. It mentally tracks the supposed flow of money through the economy without providing any physical analysis. It does not consider how production is accomplished. Amazingly, it blames investment for lowered incomes. It says that we could all consume a multiple more if we invested less of our incomes.

That goes against the physical observation of how income is produced, and it ignores cause and effect. The problem of producing more cannot be solved by the act of spending. An individual can only spend the income that he earns from his production, or has saved from his past production, or has borrowed from the production or savings of others. The government can only spend what it first takes from current production and savings.

The idea that Spending causes Production is a reversal of cause and effect. We can only exchange what we produce (or promise that we will produce). Exchange with other people is called Spending.

All we need for a utopia is to reverse cause and effect. All we need for infinite energy is to reverse a few physical laws. All we need for a happy and productive society is to give all resources to the government for wise spending and multiplying.

- -
Keynes' Propensity to ConsumeGet a feel for it. I don't recommend reading it deeply.
Marxists.org

This is a chapter from "The General Theory of Employment, Interest and Money" by Keynes. This type of dense writing impresses some people. To me, it is used to obscure any proposed theory and prevent any clear analysis. Any criticism can be met with "you didn't properly understand the detail in section 3.6".

Let's Counterfeit Our Way to WealthI wish it were true.
02/2009 - Easy Opinions

A fantasy supports the idea that our government increases the wealth of our society when it borrows and spends. Supposedly, government spending increases wealth by a conservative multiplier of 1.5.

There is no wealth multiplier from the flow of money. If there were, we would all be living in Aruba by now as a result of huge government borrowing and spending.

See posts about Keynes and his economics ...Search Label: Keynes at EasyOpinions

Keynes' Brilliant Moment

Fred:  Keynes proposed that everyone would have a job if the government would print more money and distribute it widely.
Mike:  Distribute it to me, and I wouldn't have to work.

A lost recording, England 1932:

Keynes:  There must be a way to end this depression. Along the way, we can show that government can be good, and business is bad.

Assistant:  How to do it?

Keynes:  I have it! There is not enough demand for goods and services. Something changed, and people stopped wanting enough stuff. They became suddenly and disastrously frugal, and no longer want to buy things.

Assistant:  With a raise, I would buy more things.

Keynes:  Forget the raise. If only we could find Martians who would buy more of our stuff, then people would work for the Martians. The increased demand would get money flowing, like a river, and we would all be rich.

Assistant:  Sir, we had a long talk about the Martians. We have gone over that.

Keynes:  OK, yes, no Martians. Where else can we get demand?

Assistant:  How about the French and Germans?

Keynes:  They are not rich enough. They are still progessing toward wealth through adaptation to Socialism, and they haven't yet adapted. They have this stupid notion that they should sell more of their stuff to us, not buy more stuff from us.

Assistant:  If you and I both had more money, we could buy things and help to raise demand.

Keynes:  More money? Eureka! The government can print up the stuff and spread it around. And, I can get more money by advising the government. The workers will chase those pieces of paper like catnip. They will become used to working again, instead of being lazy and stupid.

Assistant:  More people may find work. But Sir, the value of money will fall and prices will go up. Everyone now working and saving will be silently taxed to employ those extra people. And, what will happen when the stimulus stops?

Keynes:  First, we and our friends in government will all have more money. That has to be a very good thing. Second, in the long run we are all dead. Forget about tomorrow, it is in the future.

Assistant:  So, I get my raise?

- -
Use Inflation to Fool People
Keynesian economists expect most people to be slow-witted and unable to make rational economic decisions. The government tries to fool people into working harder by inflating the currency to just the right amount. But, it doesn't work for long.

"Keynesian Economics" in The Political Dictionary
Understand politics by knowing the meanings of things.

Econ 201: The Myth of the Economic Multiplier
You don't create $40 in wealth by paying $10 to mow your lawn.

The Deadweight Loss of Taxes
Collecting $1 in extra tax kills $2 in production.

A Short Argument Against Stimulus
It isn't so stimulating when you know that it must be paid back.

Let's Counterfeit Our Way to Wealth
If Obama and Keynes are correct, that there is a 1.5 wealth multiplier on spending, then $100 in spending produces $150 in wealth, and we should all benefit from counterfeiting. It is not my fault that the belief in a multiplier is so outrageous that it leads to this outrageous result.

DIY Stimulus Policy

Fred:  What is your analysis of stimulus spending?
Economist:  "4=2+2" so stimulus will increase GDP and jobs.
Fred:  Are you nuts?

Economist:  Oh, I meant to say "GDP = All production in the U.S.", so stimulus will increase GDP and jobs.
Fred:  I don't get it. That's just a definition.

Economist:  Oh, I meant to say "GDP = C + I + G + (X - M)", so stimulus G will increase GDP and jobs.
Fred:  That's better.

This is one of our most impressive installments of DIY. Government economists support giant "stimulus" spending to end our recession. We explain the tricks of the professionals, so that you can create fiscal (spending) policy at home.

Don't panic. This is a "high concept" idea that would be less impressive if it were complicated by details. Just appreciate the grandeur of analyzing the entire production of 300 million people, simply by giving it a name.

Don't be afraid of the few formulas you will see. They are only a fancy way to add things up, and they look great on a cocktail napkin. Any formula will amaze your friends and show your deep insights into finance. This is exactly the same effect enjoyed by graduates of Harvard Business School.

Read more ...

The GDP Formula For the Economy

The detailed interactions that describe the U.S. economy are many, complicated, and mostly not understood.

In the meantime, many macro-economists use a short formula which is easy to remember. They use it to promote deficits, spend $789 billion on stimulus, impress the non-PHD's, and win arguments on blogs. You can use this formula as an amateur. It is merely addition, but it does require memorizing the letters (the variables or quantity names) to show that you are unusually intelligent.

 Y (same as GDP) = C + I + G + (X - M)

You can casually say at a party "Stimulus increases G, which increases Y and creates more jobs throughout the economy".  The effect is electric. Politicians will applaud.

The quantity "Y" or "GDP" is Gross Domestic Product. That is all of the goods and services produced in the country.

Just like "DIY - Garden Shed", we will build from the bottom, giving you hints along the way. Here is the foundation:

GDP  =  Total U.S. production. All goods and
        services produced during the year

That is merely a definition. We can make it less boring by slicing GDP into philosophical pieces. Really, schools award degrees in this stuff. Here is our first slice:

GDP  =  Consumption C  +  Investment I

This says that everything we produce can be assigned to two categories. "Consumption" is what we use personally, like food, clothing, and automobiles. "Investment" supports businesses to produce those goods and services, like supermarkets and automobile factories. There are some gray areas, but why worry? The macro-economists don't.

How does government fit in? We slice again:

GDP = Consumption C + Investment I + Govt Spending G

Consumption is spending for individual use, also called consumer spending. Investment is spending to support businesses, like buying machinery. Government Spending is everything purchased by government.

Notice that there is no "Government Investment". We know that government builds a few useful things like bridges, but government doesn't try to make a profit (more is the pity) so it is all called Government Spending.

We have left out "Exports X - Imports M" for now. You can look below for that explanation, so that people don't accuse you of reading "only that stupid DIY post".  "X - M"  is "Exports minus Imports". It is there mostly to show that you understand the complexities of the economy, after completely ignoring all of those complexities by relying on this stupid formula.

That is the GDP Formula. I know you were looking forward to more complexity and hours of study. You may even be angry, thinking now that this whole post is a big joke. You think it can't be this simple. Our leading government economists and Keynesian pundits just can't be using this simple formula as justification for their economic policy. I share your anger. Don't blame me. That is just how it is.

About GDP

Here is the GDP Formula again. You will find out how our government uses this formula. Sadly, this is not a joke.

GDP = Consumption + Investment + Government Spending

This formula is simple and absolutely true. People are dazzled by its truth, but are not aware of how useless it is. It is only a broad mental exercise for thinking about the money spent in our economy.

GDP is everything produced in our country. An economist notices that your income results from selling what you produce. You sell your effort each day to earn your salary in money. You spend your salary to buy the food, clothing, and services which support your life. Your income in cash comes from your share of the goods and services you help to produce. So, production and income are two sides of the same coin. All production represents someone's income.

In general, more GDP is good because more production means more income to the people of the country. Government economists look for ways to increase GDP, especially during recessions. They most often find their answer in the GDP Formula above. They see that GDP would be larger if one or more of its parts were larger.

Consumer Spending

Economists note that consumer spending is 70% of the economy. This means that about 70% of all purchases are by people for their personal benefit. Looked at another way, 70% of what is produced (GDP) is made for people to use personally.

During recessions, people spend less on consumption because some are out of work and others want to save more, in fear of losing their jobs.  GDP is produced by people, so higher GDP is associated with more people working. Government economists look at the GDP Formula and conclude that if people would spend more on consumption, there would be higher GDP and more jobs, ending the recession. This extra consumption would be economic "stimulus".

It is difficult to encourage people to consume more. A few tries have been made with Cash for Clunkers for buying autos, and cash subsidies for buying homes. But, people can't consume much more if they are out of work.

Both presidents Bush and Obama gave one-time tax refunds or payments to people. These didn't do much for the economy. Government economists complained that people saved most of it instead of spending it all, reducing the "stimulating" effect.

I don't understand why saving (investment) is supposed to be worse than spending. According to the GDP Formula, they add equally to GDP. I suppose that is just inconvenient to what politicians want to do. They want to spend.

Investment

Nope. The government doesn't know how to invest, and it hates making a profit. Investment is done by the prosperous business people that the government takes taxes from. Government isn't about to give back that money for investment, followed by "trickle down" prosperity.

Government Spending

Now we are on to something. Government economists interpret the GDP Formula as showing that government spending increases GDP. That is something that government can do with a few votes, and spending is something that all politicians like to do. Any recession creates calls for much more government spending, and they do it.

The Personal Spending Formula

I said above that the GDP Formula is true but useless. Let's get a feel for that by looking at a smaller, friendlier, more understandable relative  The Personal Spending Formula:

My Spending
   =  Restaurant Meals + Savings + Other Spending

In general, more of My Spending is good because I enjoy most of the things I buy. I often daydream about buying more things to be happier. The Personal Formula seems to give me guidance: I should buy more restaurant meals to increase My Spending. In fact, I might think it tells me that I should eat out all the time, and take friends and family with me. More spending on restaurant meals is good, and the more the better.

I hear some shouting in the audience, that I can't just increase what I spend on restaurants. I would have to decrease what I save or decrease what I spend on other things. I might enjoy more restaurant meals, but I would have to cut elsewhere. In fact, I can't really change My Spending at all (!) because I have properly included Savings in the formula.

By definition, my entire income is equal to My Spending, and I can only allocate my income to different purposes. I can't raise or lower My Spending by spending more or less in one category, because I must adjust the other categories. The formula is correct, but it can mislead me about how the quantities affect each other.

To increase My Spending, I would have to work more hours, or find a better-paying job, or save/invest in a growing company. None of that is represented in the Personal Spending Formula.

I could buy more restaurant meals if I cut Other Spending. I might spend less on maintaining my car and use the difference for more restaurant meals. But, my car might break down, and that strategy could work out as a bad choice. Whatever happens, the Personal Spending Formula will reliably add up the results, but it does not say what I should do or what will happen.

An increase in my income would allow me to spend more in one or more categories. The Personal Spending Formula doesn't tell me that I can increase my income by purchasing more restaurant meals or anything else. That would be a crazy interpretation of a formula that merely adds up my spending choices.

The Personal Spending Formula is absolutely true, which impresses people at first glance. But, it is worthless for guiding me to earn more income. It only says that I must spend less in one category if I spend more in another category.

Borrowing Savings For a Price

If I want to buy a new television for $1,000, and I don't have enough in savings, possibly I can borrow the money. This works if I can reliably save enough to pay for the TV plus interest, and I don't want to delay the purchase until I have saved the money.

I could buy the TV for $1,000, and pay $80 per month for the next 15 months to pay off a $1,000 loan. My total cost to buy the TV this way would be $1,200. So, I could pay an extra $200 to the lender to buy the TV now, rather than save $80/month for 12.5 months to buy the TV later.

It seems that I have increased My Spending by $1,000 by getting that loan. Actually, I increase Other Spending by $1,000 when I buy the TV, and I decrease Savings $1,000 by getting the loan. Savings has become negative.

Negative savings means that I owe money. I put less into savings over time than I have now taken out. I will pay about $67/month into savings as I pay off the loan, and I will pay the loan company about $13/month interest for the use of the money. Savings will become $0 after 15 months (assuming it was $0 to start), the loan will be paid off, I will own the TV, and I will have paid about $200 to borrow enough savings to buy the TV sooner rather than later.

This is interesting. "My Spending" did not change because of the loan. Other Spending went up by $1,000, and Savings went down by $1,000, offsetting each other. This contrasts with the usual assumption that taking out a loan increases "spending". In fact, loans are a transfer of savings for a price.

This personal accounting agrees with what the society sees. I bought $1,000 more of something, but the lender bought $1,000 less of something. These cancel out for the society, and they cancel out in a proper personal accounting.

Confusion

I confess that I introduced some confusion, but only the same confusion that government economists use. The Personal Spending Formula should have looked like this:

My Production or Income
   =  Restaurant Meals + Savings + Other Spending

It is entirely true that Production = Income = Spending. We can account for Production by either valuing everything that is produced as GDP, or adding up all Income, or adding up all Spending (when Savings are properly accounted as a category of spending).

Here is the confusion. When I say   "My Spending = . . .",   that choice of word gives the impression that I can change what I spend in total. "Spending" seems to be something that I can do more or less of. In fact, when we properly account for transfering money into Savings/Investment, I can't change the total of My Spending, I can only allocate it between Restaurants, Savings/Investment, and Other Spending.

If I had said   "My Income = . . .",   then it would have suggested the correct conclusion from the start. "My Income" depends on what I earn, and I can only allocate it between different types of purchases, including Savings/Investment. It becomes much clearer that what I earn doesn't change because I spend more or less on consumer goods rather than on Savings/Investment.

Stimulus

Here is the GDP Formula again:

GDP = Consumption + Investment + Government Spending

It should look different to you now, after reading the section above.

There, we saw that the Personal Spending Formula is a true representation of how I might allocate my income among different categories of goods. It is useless for deciding what I should do to increase my income. It doesn't express or relate any of the complexity in my life that determines what my income is or what it could be.

The GDP Formula has the same qualities. It is definitely true. But, it is merely a true statement about how all GDP (production) can be allocated to various categories, in principle, philosophically.

It is crazy to use the GDP Formula to claim that increasing Government Spending will increase GDP. The GDP Formula only says Government Spending buys some part of what is produced. It says nothing about how we could produce more or increase employment. The GDP Formula says nothing about the immense complexity within our society. If anything, the GDP Formula tells us that there is a tradeoff, that more government spending requires less personal consumption and/or less investment.

Government economists say that the government is in a special position to create "stimulus", to borrow money and increase spending now to create jobs now. Although spending will go down in the future when the loans are repaid, they say the economy will have time to recover.

There is a problem in this reasoning. Borrowing does not increase "spending" overall. The government spends more, but the lender spends (invests) less to support business. It is mostly a wash. If anything, resources lent to the government are applied with a lower productivity than they would be by individual investors in our society, reducing employment.

Your car has a speedometer that reports how fast you are going. You would be crazy to think that you could increase your speed by grabbing the needle and pulling it toward 50 mph.

The GDP Formula reports (only in principle) how production is allocated among uses. You would be crazy to think that you could increase production merely by allocating more of it to the use of government. That is what increased government spending does.

The GDP Formula is a magic trick. Observers see that the formula is true by definition. Then the magician economist interprets the formula in a crazy way to support the taxing and spending desires of the politicians who employ him. Assuming that government economists are smart and college educated, I think that they are lying, not merely mistaken about this crazy interpretation of the GDP Formula.

The Complete Keynes Formula

Total Production Y = 
  Consumption C + Investment I + Govt Spending G 
  + Exports X - Imports M

The Keynes Formula divides all production within a country into categories. Consumption + Investment + Government Spending seems to include everything, so what is (Exports - Imports) doing there?

The Keynes Formula accounts in principle for every spending transaction within a country and assigns each transaction to Consumption, Investment, or Government Spending. But, usually that is not quite equal to the goods and services produced within the country.

If a French company buys from the U.S., the spending is done in France for goods manaufactured in the U.S. This foreign spending on U.S. exports should be added to U.S. GDP.

If a U.S. company buys from France, the spending is done in the U.S. for goods manufactured in France. This local spending on French imports does not represent U.S. GDP, so it should be subtracted from the spending figures.

So, if we start with "All spending transactions within the U.S.", we can add exports and subtract imports to get the true dollar value of U.S. GDP (Total Production Y above).

Showy Complexity

The Keynes Formula is contrived.

First.  The division of GDP into Consumption, Investment, and Government Spending is arbitrary. It seems to me that Government Spending is in the formula merely to refer to it as a component of political strategy.

I could as easily write this formula:

GDP = Consumption + Investment 
      + Video Games + Cat Food

Then I could argue for increasing GDP by subsidizing the purchase of video games and cat food.

The categories of spending seem analytical, but they aren't used for any further analysis. There is no discussion about which is better, and there couldn't be; these terms are too vague to provide an analytical insight.

Keynes did not make a distinction. He famously recommended distributing cash to the public, or paying them to dig holes and fill them up. Any means of increasing consumption, investment, or government spending was supposed to increase overall production. Of course, politicians have always preferred government spending.

Second.  The inclusion of "Exports - Imports" adds unneeded complexity. Our government certainly buys some foreign goods, and sells government services to foreign countries. So, part of "Exports - Imports" is Government Spending. Who cares? The Keynes Formula is only used to incorrectly claim that increased Government Spending must increase GDP. That fallacy is the central point of this post.

The value of including "Exports - Imports" is to present another absolutely true and complex fact about GDP accounting which is irrelevent to the discussion. It puts another gloss of legitimacy on the incorrect interpretation of the Keynes Formula.

Third.  Keynesian economists have analyzed the failure of one-time tax rebates or subsidies to "stimulate". They conclude that the public didn't spend enough of their new money. They saved much of it or paid down debt, which is another way of saving.

But, the interpretation of the Keynes Formula by Keynesian economists would make consumer spending, saving, and investment equally "stimulative" and equally powerful in raising GDP. This bias toward spending and against saving is not part of the Keynes Formula, but they illogically use the Keynes Formula as a quick justification for their political preferences.
 

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Keynes, Digger of Holes
12/2008 - EasyOpinions

No one should trust a theory that predicts greater prosperity from digging holes. Yet, this is the theory by Keynes that Obama is following, and that many past presidents have followed to forcibly change our society. We will supposedly create even more wealth in the future by wasting our current wealth today.

I know. I must be wrong. No one could believe such a thing. Certainly no president of a great country would listen to a dead crank who spouted such nonsense. But, there it is.

There is a story at the link about Keynes dirtying some towels in a washroom and claiming that he had just helped the economy by creating work.

How many obviously false statements must a person make before the quality of his entire thought is in question? The limit has not yet been set for Keynesian economists and politicians.

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The Keynesian Accounting Trap
06/17/10 - 12/21/09 - Mises.org by Robert P. Murphy

[edited]  I think Krugman [a Keynesian economist and pundit] is committing a very basic error. He is confusing the Keynesian accounting identity [the GDP Formula above] with a causal theory of how changes in one of the variables lead to changes in the other variables.

This formula very often misleads people that the way to increase output [GDP] is to try to increase one of the variables on the right side. But this is a fallacy. The accounting identity must always be true, but it can remain in balance if other variables on the right side fall.

Krugman is wrong even within the Keynesian framework. For example, Keynesians often use this formula to argue that increases in government spending are necessary to "fill the gap" when private consumption and investment are below "potential GDP." They naively assume that boosting Government Spending on the right side of the formula will lead to an increase in GDP on the left side. But, that relies on the Keynesian theory of how the macroeconomy works; it doesn't follow from the formula itself.

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Bigger Government Is Not Stimulus
12/15/08 - Cato Institute by Dan Mitchel   (YouTube video 7:29)
A video by the Center for Freedom and Prosperity Foundation.

Both theory and evidence show that allowing politicians to spend more money does not produce better economic performance. Keynesian theory doesn't make sense. Government can only put money into the economy by first taking it out as borrowing. Transferring the economy’s money from its left pocket to its right pocket is not a recipe for growth.

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Macroeconomics is Astrology, Not Science
01/30/09 - EO -> RealClearMarkets

Frank J. Tipler is Professor of Mathematical Physics at Tulane University:

[edited]  The inability of macroeconomic theories to make accurate predictions about an entire economy means that those economists do not know what they are talking about. Our leaders are being advised by macroeconomists who haven’t got a clue where they are leading us. Their actions may lead us out of the current recession, or they may lead us into a depression as bad as the Great Depression.

Use Inflation to Fool People

We Were All Keynesians Then
01/09/06 - Cato.org by economist Ike Brannon
(via The Angry Economist)

Keynesian economists expect most people to be slow-witted and unable to make rational economic decisions. The government tries to fool people into working harder by inflating the currency to just the right amount. But, it doesn't work for long.

[edited] In 1961, John Muth published in the journal Econometrica, demonstrating that people thoughtfully use available information to predict future prices, and then make economic decisions based on "rational expectations".

Muth's insight was radical during that heyday of Keynesian economics. Today, it is an accepted part of the canon of economics.

"Rational expectations" says that entrepreneurs and workers do not assume that prices will be constant when they need to forecast future prices. They use all available information to estimate what prices will be, and their estimate is correct on average. They will make mistakes, but they will not be consistently wrong.

Muth demonstrated that rational expectations explained prices quite well for a market in hogs, thought to exhibit wide, predictable price swings.

Muth's paper was published at the time that Keynesian economics had become ascendant in the political world. Policymakers thought they could permanently increase employment by increasing inflation. Supposedly, higher inflation fools workers, who mistake a rising dollar wage for a real increase in their buying power. As a result, people would take jobs they would not otherwise take, and work more hours than they would otherwise work, increasing employment and output.

Muth's work explains why the 1970's economy experienced "stagflation", slow economic growth and inflation at the same time. Rational expectations predicted that people may not always make economically optimal decisions, but they can't be consistently fooled by government policies.

Keynes Likes Totalitarians

Keynes Politely Explains How to Destroy Civilization
02/27/09 - Blog.Mises.org by Jeffrey Tucker

The late economist Lord John Maynard Keynes regarded his own theories as a best fit for totalitarian societies. It is so much easier to achieve full employment when you can tell everyone what to do and decide what they will be paid. Every member of an ant colony is employed, and seemingly happy.

Keynes impresses me with the long, jumpy, tedious construction of his sentences, to express the simplest and fuzziest thoughts. I find that saying something directly is easy. Saying nothing, or everything, with detailed qualifications and exceptions, in one sentence, is quite difficult. Why bother with paragraphs when long sentences are so much more impressive?

[edited] I'm sorry, but reading Keynes gives me the chills. I can easily imagine his dispassionate narrative about events in a Gulag, justifying every horror with a pseudo-scientific rationale made up on the spot.

Oh wait: he did do that. From the 1936 foreword to the German edition of The General Theory:

Nevertheless the theory of output as a whole, which is what the following book purports to provide, is much more easily adapted to the conditions of a totalitarian state, than is the theory of production and distribution of a given output produced under conditions of free competition and a lance measure of laissez-faire.

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The General Theory of Employment, Interest and Money, Chap. 24
Dig into the thought of Lord Keynes at Marxists.org.

The Political Dictionary: "Keynesian Economics"
A satirical definition, unfortunately true.

Keynes, Digger of Holes

Obama’s Keynesian Error
12/29/08 - ChicagoBoys by Shannon Love

No one should trust a theory that predicts greater prosperity from digging holes. Yet, this is the theory by Keynes that Obama is following, and many past presidents have followed, to forcibly change our society. We will supposedly create even more wealth in the future by wasting our current wealth today.

I know. I must be wrong. No one could believe such a thing. Certainly no President of a great country would listen to a dead crank who spouted such nonsense. But, there it is.

The promised future wealth has never appeared. What will our leaders say when, again, the wealth does not appear, after wasting the resources that we have today. "So sorry. We just had to try something."

Read more ...

[edited] Keynes famously said that the government could stimulate the economy by simply burying large amounts of money in the ground and then letting people dig it up again. The money spent to dig up the money would drive the economy again.

Keynes' economic theory says that the movement of money itself from person to person creates a good economy. Keynes thought recessions occurred when people saved too much and spent too little, causing the money to stop moving. Government could “prime the pump” of the economy by taking the saved "static" money and spending it.

Money communicates information not by moving, but by differences in prices. Keynes was like a naive individual who discovers that phones lines carry information with electricity. He then decides that pushing more electricity will send more information. In reality, all he would get is a squeal. Likewise, moving money through the economy does nothing if that movement does not transmit information about the real value of economic choices.

The New Old Big Thing in Economics
01/08/09 - Online.WSJ.com by Sudeep Reddy
Another story about Keynes:

During a 1934 dinner in the U.S., one economist carefully removed a towel from a stack to dry his hands. Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers.

Keynes point was brilliant, if you forget that the restaurant owner had already paid to provide clean towels. Keynes didn't offer to pay for the mess. The owner had to pay to replace the towels. Keynes's ideas are wonderful, as long as you can find owners to take resources from. After that, no more clean towels, and no need for restaurant workers to keep them available.

It seems that Keynes liked to be destructive, then say he was really helping everyone out.

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"Keynesian Economics" in The Political Dictionary
Understand politics by knowing the meanings of things.

Econ 201: The Myth of the Economic Multiplier
You don't create $40 in wealth by paying $10 to mow your lawn.

The Deadweight Loss of Taxes
Collecting $1 in extra tax kills $2 in production.

A Short Argument Against Stimulus
It isn't so stimulating when you know that it must be paid back.

Let's Counterfeit Our Way to Wealth
If Obama and Keynes are correct, that there is a 1.5 wealth multiplier on spending, then $100 in spending produces $150 in wealth, and we should all benefit from counterfeiting. It is not my fault that the belief in a multiplier is so outrageous that it leads to this outrageous result.