THE debate rages on about whether the chancellor should implement a Plan B, or C or D, or even Z. There’s a plethora of alternatives for George Osborne to choose from, but many of them share a key common theme: that an increase in public spending will boost overall output in the economy.
This was one of the revolutionary new ideas developed by the economist John Maynard Keynes, which he called the “multiplier”. An increase in public spending means that more people are employed, whether in the public sector itself or in building infrastructure. These people spend more money in turn, and the effect ripples across the economy. The final impact is a multiple – hence the word “multiplier” – of the initial increase in spending.
This seems to be common sense. But common sense can often lead us astray. It seems to be common sense that the Sun goes round the Earth, as it does travel round the sky after all.
So what does modern economics have to say about the size of the multiplier? Keynes thought it was between two and three. He believed an increase of £1bn in public spending would eventually increase GDP by between £2bn and £3bn.
Great news if this is true. The tax take from an increase in spending is around 40 per cent, and 40 per cent of £2bn or £3bn is around £1bn. So public spending creates jobs, boosts output and pays for itself.
But here is the bad news. Modern estimates of the multiplier put it much lower. In the late 1970s, I was involved in the first systematic comparison of the multiplier in the three leading macroeconomic models of the UK economy, including that of the Treasury. We estimated that the true multiplier was only between 0.5 and 1.2.
The Journal of Economic Literature, one of the world’s top academic journals, published a symposium in September 2011 on the size of the multiplier. Even the Keynesian-based models of the US economy only put it at between 0.8 and 1.5. And the figure will be lower for much more open economies like the UK, because a bigger proportion of any increase in spending simply leaks out of the economy in imports. Nobel Prize winner Robert Barro argues that even spending targeted to have very low import content has a multiplier of around 0.6.
Poor old multiplier, just look how small it is! Even at the optimistic end, modern economics suggests that the eventual increase in national output will hardly be any bigger than the increase in public spending. Many estimates put the eventual rise considerably lower.
There are all sorts of reasons for the tiny multiplier. Some spending disappears into imports. Also, if interest rates rise, pushed up by government borrowing, the value of government bonds falls and there is less wealth. But the central point is that economics itself suggests that more public spending is not the growth panacea it is purported to be.
Paul Ormerod is an economist and partner at Volterra Partners, and author of Positive Linking: How Networks Can Revolutionise the World (Faber & Faber).