A Flat Pyramid Scheme

In the course of checking a claim by Congressman Jim Langevin, C. Eugene Emery, Jr., offers this explanation of the calculation behind the “multiplier effect” allowing Democrats to claim, as Langevin did, “for every $1 we spend on unemploymen t benefits, $1.90 is put into our economy”:

When you give $1 to people who have lost their jobs and they have run out of savings, those dollars get spent. So Mary gives it to Mike down the street to buy some of his fruits and vegetables. Mike, who relies on customers like Mary, might put 25 cents in the bank but use the rest to buy seed and fertilizer from Tom’s store in town. Tom might save a dime of the 75 cents he got from Mike but use the remaining 60 cents for a new pair of glasses.
When economists calculate the gross domestic product, they add up all those transactions (excluding the amount set aside in savings and money that ends up overseas if you buy foreign goods). In this limited example, Mary’s $1 has added $2.35 ($1 plus 75 cents plus 60 cents) to the gross domestic product. Yes, it’s still just $1, but by passing it along it has helped three people.

For purposes of economic theory, this is an interesting consequence of the definition of the GDP, but in contriving a policy to increase economic activity and employment, it’s not so useful. The GDP calculation does not differentiate between a dollar that Mike spends because Mary transferred her government cash to him and a dollar that Mike pulls out of his savings because he thinks investing in his business is a better strategy. To get the economy rolling of its own volition, policies must encourage the latter.
Since a government in deficit has no savings of its own, it must take Mary’s dollar from somebody else, whether decreasing some other expenditure, increasing taxes, or borrowing from the future. That means that Mike might reasonably expect the personal profits from his business to decrease, encouraging him to find other things to do with his money than invest in his economic output (savings, foreign transactions, etc.).
Whether we continue to extend unemployment benefits is more a moral question than an economic one. But on the economic side, priority number 1 ought to be encouraging business owners and entrepreneurs to take on the risk that ultimately provides folks like Mary with employment.

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Phil
Phil
11 years ago

{But on the economic side, priority number 1 ought to be encouraging business owners and entrepreneurs to take on the risk that ultimately provides folks like Mary with employment.} I’m worried that banks are not aiding those who would invest in businesses right now. Without access to credit those who can grow the economy will not be able to. This may be the consequence of newly found caution by the banks and large investors, the situation in Europe, or as I suspect the willful witholding of capital. The wealthy on Wall St and in the major banks may be playing a waiting game. They betting that the voters (tea party, stupid rabble, thickfingered clowns)will turn out the politicians that have imposed real limits on their greediness and the situation will be better for them after the midterm elections or after the 2012 presidential election. That’s just conjecture, but a major bank just cancelled my business’s line of credit. The reason I asked. Read the fine print said the sympathetic voice on the phone. You signed it. Was it something I did? No. I don’t understand. I had hoped to double my annual purchase of oyster seed this year using that credit. Sorry. We reserve the right to change the terms of the agreement any fuc$all time we choose. Have a nice day. I’ve had to scramble to find other sources but have had to settle for roughly the same investment in the future as the last two years. I was willing to increase my economic output or at least to try. I’m sure you have heard from your families and friends their stories about their credit limits being set at what they owed on their credit cards and then cancelled altogether. It would seem as though there are some wealthy… Read more »

Warrington Faust
Warrington Faust
11 years ago

The “multiplier effect”, or the turnover of money in the economy, is one of the oldest economic tools. There is a presumption that the money stays in “the economy”. With the huge increase in the amount of foreign goods, a very large portion of “spending” is money leaving our economy. I am sure that attempts are made to adjust for this, but I am doubtful of the efficacy.

mangeek
mangeek
11 years ago

This whole ‘generates $X in the economy’ argument is ridiculous. I suppose it would make sense if our problem was people -saving- money instead of spending it, but that certainly isn’t the issue. Americans were at a 0% savings rate before the collapse, and even when consumer confidence is at record lows, the savings rate is only about 5%. Ideally, individuals would save 12% or so if they plan on retiring.
Since that money wasn’t being ‘saved’ in the first place, I fail to see how having the government take it out of a working part of the economy and put it somewhere that’s not working is any better than just letting it work on its own, unmolested.
Instead of trying to focus on ‘getting people to spend’ or ‘making loans to businesses’, we should be encouraging a culture of frugality and savings, so we can ride out rough times on accumulated wealth, rather than depend so wholly on debt.

Phil
Phil
11 years ago

Instead of trying to focus on ‘getting people to spend’ or ‘making loans to businesses’, we should be encouraging a culture of frugality and savings, so we can ride out rough times on accumulated wealth, rather than depend so wholly on debt.
At a time when we need to be bold you suggest just the opposite. Instead of investing in the future you urge that we bunker down to what kind of future. You say we should rely on accumulated wealth. We don’t all have the luxury of trust funds to sustain us in these times.

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