10/31/2013 04:52 pm ET Updated Dec 31, 2013

Government Spending - Trick or Treat?

Government spending is what our two political parties are fighting over. At the heart of this dispute is something called a "multiplier effect". Here's an example from the October 2013 AARP Bulletin. The sidebar for "Social Security's Impact," claims:

  • $2.00 is added to the U.S. economy for every dollar of Social Security benefit paid out
  • 9 million jobs are supported by the combined spending of Social Security recipients and businesses.
  • $1.5 trillion was added to the total economic output by Social Security in 2012.

These statistics in favor of Social Security are based on the multiplier effect.

What is a multiplier?

Here's the simplest definition I could find:

An effect in economics in which an increase in spending produces an increase in national income and consumption greater than the initial amount spent. For example, if a corporation builds a factory, it will employ construction workers and their suppliers as well as those who work in the factory. Indirectly, the new factory will stimulate employment in laundries, restaurants, and service industries in the factory's vicinity.

But note that this definition of the investment multiplier effect leaves out three other ways of launching a positive fiscal multiplier effect. The first is by government spending.

Two other ways are through tax reductions and growth of exports.

Where did the idea of a multiplier effect come from?

The first formulas for multiplier effects were derived from John Maynard Keynes' classic macroeconomics text, A General Theory of Employment, Interest and Money (1936).

Keynes theory was the impetus behind President Franklin D. Roosevelt's New Deal program to combat the Great Depression of the 1930s. The multiplier effect kicked in when Roosevelt and Congress used government spending to employ Americans through the Works Progress Administration (WPA) to build and repair our infrastructure.

As a result of Roosevelt's success, government spending versus private investment is what Democrats and Republicans are now arguing over.

Why Republicans reject the multiplier

Republicans say they repudiate Keynes and his multiplier effect, but their economic theories belie their words. Republicans don't really reject the multiplier - they just use it very selectively.

For example, one conservative critique of Keynes' multiplier effect is that it suggests that unlimited growth is possible - it is like an "economic perpetual motion machine". Yet it was Ronald Reagan's team that came up with the slogan, "trickle down economics". This is just another name for one specific kind of fiscal multiplier effect, the investment multiplier.

As the example in the definition above shows, when a corporation invests capital (e.g., buys a new factory), the positive effects of that spending spread far and wide beyond the original recipient(s) of the money. The recipient's income "trickles down" into other sectors of the economy, often creating more consumer buying and new jobs.

This investment multiplier is no more of a perpetual money machine than the government spending multiplier; in fact, some researchers say the private investment multiplier effects are quicker to dry up than those from public spending by government.

Another objection made to the multiplier effect by some is that "centralized injections of spending crowd out other economic activity." Thus, Republicans claim there are no significant effects from a government spending multiplier. This cancels out the first argument in which they ridicule this multiplier effect as infinite.

Yet Republicans repeatedly espoused their version of the multiplier effect during the last Presidential election. They fought vigorously for no tax increase on wealthy "job creators," the ones who supposedly would create an investment multiplier effect.

It's true, Keynes' equations indicate that tax breaks have a positive multiplier effect similar to that of increasing government spending, but the T in the formula doesn't specify tax cuts to the rich! It refers to any tax breaks that increase consumption. The multiplier effect kicks in from the rising demand for new goods and services. This increase in consumer demand results in new investment by corporations, new jobs, and increasing wages.

The bigger picture

To sum up, there are two sides to the multiplier argument over job creation. One side says to start with government spending (and/or efforts to increase our export sales abroad). The other side says to start with a tax break or tax credits for the rich so they'll invest in corporate growth.

Both sides are missing the boat.

Empirical research shows one sector creates more jobs than any other. The real job creators are small businesses with less than 50 employees.

Small businesses with 1 to 49 employees created disproportionately more new jobs before the Great Recession. But this sector is no longer expanding - it's shrinking fro multiple reasons, one of which is that Congress raised the 2013 income tax rate for this group. Their tax rate is higher than any other group in the nation!

Spending on and by small businesses is where the real multiplier effect lies - looking increasingly like a ghost.