For every multiplier there is a de-multiplier


5. For every multiplier there is a de-multiplier.

Governments sometimes justify moves to stimulate the economy by pointing to the multiplier effect. There are, indeed, multipliers. In a simplified example the government might inject a million pounds into the economy. If the recipient buys a boat and two cars and redecorates their house, this provides jobs for boat-builders, car manufacturers and dealers, painters, plasterers and handymen. And when these people in turn spend what they receive, yet more economic activity is generated.

There is a catch, of course. It is that government gets that money from the private sector. It takes it in taxes, leaving people with less spending power; or it borrows it, thereby increasing the interest rates the private sector has to pay, discouraging private investment. Or the government can print the money, ultimately taking out spending power by reducing the value of everyone else's money.

The money the government takes out of the private sector to finance its stimulus is money that would have been involved in other economic activity. Unless it were buried somewhere, it would have been working its own multiplier as it passed from hand to hand. It might have been used to buy the boat, cars and home redecoration that the government stimulus financed, or it might have created a stimulus in other sectors. The removal of this money in effect constitutes a de-multiplier, inhibiting the second, third and subsequent waves of economic activity it might have triggered.

There is a problem in that the private economic activity now squeezed out was a real response to demand, whereas the government stimulus does not necessarily go where it is needed for resources to be allocated efficiently. Furthermore, because the private sector is generally more efficient in its use of resources than the state sector, the chances are that the de-multiplier is larger than the multiplier the government claims credit for. The problem is that on the political landscape everyone can see and identify the government stimulus, whereas few people can spot the private sector activity which it has thwarted. Political leaders claim credit for the one without attracting blame for the other.

Governments sometimes argue that their activities shorten the time it might take for resources to be reallocated, and thereby minimize the hardship engendered by an economic downturn. This misses the point that it reallocates them to areas where production cannot be sustained without that government demand, and builds in imbalances that will cause later hardship when they readjust to real economic conditions. Instead of trying to create public multipliers at the expense of private ones, governments should boost the private ones by cutting the taxes it imposes on them.

This is part of Dr Pirie's ongoing series: Philosophical Observations on Economics.