One of the recurring general themes in my years of blogging is the flawed logic in many of the ideas proposed by some of our most educated and brightest commentators and policy makers. There are many books that address the reasons that smart people make bad decisions and reach terribly flawed conclusions.
Underestimating the emotional content of our decisions and conclusions; poor understanding of the role of probability; lack of willingness or capability to acknowledge the unknown and uncertain; and incomplete or nonexistent feedback mechanisms are a few of the many obstacles to clear thinking even amongst the brightest.
But few errors in thinking have affected us as much as the Keynesian notion of the government spending multiplier and its justification for deficit spending.
It is questionable whether Keynes himself would support the use of his theory in its current context. He proposed deficit spending in a very limited emergency context, not as a never ending economic policy. What holds true in a small limited scenario may not hold true in larger quantities and time spans.
Think of deficit spending like chemotherapy. For a specific, serious, and properly diagnosed illness consuming toxic medicine may increase your chance of survival; but we acknowledge that the application of this solution has serious side effects and must be limited. Otherwise, the cure can be much worse than the disease.
We also understand that never ending consumption of the chemotherapy can be fatal. Even if it was successful at preventing cancer, the risk and the cost would be unacceptable.
A theory or a model is only valuable in its ability to predict. A functioning economy is so dynamic that it is hard to conceive of a theory or model so perfect that it would not have to be constantly adjusted to the harsh mirror of reality. But even that need for modification relies on logical assumptions. If the assumptions are proved invalid or wrong the only recourse is to scrap the theory.
From The Illogic of the Keynesian Multiplier in the blog Easy Opinions:
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.
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.
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 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.
Is it as simple as reversing the cause and effect? This flaw in thinking is not uncommon even among bright people. Because output is a multiple of investment and government spending does not necessarily mean that government spending causes more output. Just because my income is ten times what I spend on restaurants does not mean that dining out more often will make me richer at a multiplier of ten times my restaurant bills. The fundamental assumption of the Keynesian multiplier is fatally flawed.
And it may be impossible to measure the multiplier, since the dynamics of the economy can make it vary substantially. Furthermore the policy enacted because of the assumption of the multiplier will likely change the dynamics and the measurement of the multiplier further,