Dipping Into the Dismal Science: The Multiplier Effect


For WC’s readers, economics is, bar none, the least popular subject. Even less popular than geology. But economics are at the very heart of Alaska’s fiscal crisis, and the decisions being made by the Alaska Legislature – and in particular the leadership of the majority caucus in the state house and state senate – are going to have profound, long-lasting economic consequences for all Alaskans. The voters in Alaska need to understand more about economics.

Former Governor Sarah Palin famously refused to read an introductory book on economics. She didn’t want to read anything that might contradict what she already believed.1 But WC’s readers are smarter than The Quitter. This is your opportunity to prove it.

The multiplier effect is a macroeconomics principle that focuses on the number of times the same bit of money flows through a government’s economy. The more times it cycles through, the bigger the benefit to the government and the people who live there.2 If you spend $20 at the farmer’s market, the money goes to someone who lives in Alaska. They, in turn, spend the money on goods and services. If they take a tool to a local repair shop, the owner of the repair shop uses it to pay wages, buy parts and to buy goods for himself. So in this example, the money goes through the Alaska economy several times before dribbling Outside for goods and services.

By contrast, if you buy something from Amazon, 100% of the money leaves Alaska. The multiplier effect is one. If BP pays a worker who lives in Houston and works on the Slope $5,000 as wages, the multiplier effect is nearly zero.

The bigger the multiplier, the greater the economic benefit to Alaska and its state domestic product. The lower the multiplier – in some circumstances the multiplier can fall below one – the less the benefit.

The role of state government is also important. In a state with meaningful taxes, sales tax and value added tax recapture and keep local a chunk of every dollar spent.

And because governments can choose what they are gong to spend money on, they can select expenditures with greater multiplier effects. Wages to state employees, versus contracting for services from Outside vendors. Or, on a larger scale, spending on capital projects. If Alaska spends money on a natural gas project, the multiplier effect includes the benefits of lower energy costs. And government capital spending can stave off or at least reduce the impact of a recession. The American Recovery and Reinvestment Act of 2009, whose benefits were projected based on fiscal multipliers, were in fact followed for the period 2010-2012 by a slowing of job loss and private sector job growth. In some circumstances, the multiplier effect is so important that it makes sense for a government to borrow money to fund capital projects, especially where interest rates are very low. Like now.

Keeping the multiplier effect in mind, let’s look at the decisions the Alaska Legislature has made and is still facing.

The best multipliers and the best help for a state facing a recession is increased capital spending. Yet the Alaska Legislature slashed the capital budget. A better idea would have been to target capital spending at projects with the best economic multipliers. Interestingly, the best evidence is that any form of increased government spending has more of a multiplier effect than any form of tax cuts.

Worse, the Legislature’s refusal to address a revenue problem by increasing revenues has caused Standard & Poor’s, one of the largest credit rating services, to warn it will downgrade the state’s bond rating if the Legislature doesn’t address the shortfalls. That would mean a significant higher cost to issue bonds. That would make it even harder to to capital spending.

Do you see the dangerous cycle: decreased revenue results in reduced capital spending and exhaustion of cash reserves. That leads to a credit downgrade. That leads to higher bond interest rates. That leads to reduced capital spending. You can practically see it coming. And if the Federal Reserve decides to increase interest rates, well, it just gets worse.

The next best multipliers are for wages paid to Alaskans. Yet the Alaska Legislature slashed Alaska jobs across the state. (But still found half a million dollars laying around to spend on out of state lawyers to fight with the Governor over Medicaid expansion.)

Many of the job cuts have fallen on the public school system and the state university. In the public schools, that means larger classroom sizes and worse student/teacher ratios. And that means a decline in the quality of the education system, a long-term harm to Alaska. In the university system, it not only means the loss of jobs. The state’s funding serves as a match for grants, a different kind of multiplier. So $100 in reduced state funding may translate into $1,000 in reduced grant funding. Still worse, kids will still go to college; they’ll just do it outside as the University of Alaska becomes less attractive. And those tuition and housing dollars will be lost to Alaska.

Do you see a pattern here?

This stuff is all well understood. There is controversy over when and how much, but not over the elementary principles. Shucks, there’s even a formula:

f4e70c1db273ab96307b0068f0b74eea

Where

∆y = equivalent to gross domestic product
∆I = change in investment
b(C) = the marginal propensity to consume
b(T) = the change in aggregate taxes
b(M) = the marginal propensity to import

Application of the formula to Alaska’s situation is left as an exercise for the reader. But you don’t need to know a thing about the quantitative stuff to understand the principles.3

And if the Alaska Legislature doesn’t get a grasp on those principles soon, they are going to inflict a lot of unnecessary pain on their constituents. And do serious, long-term damage to Alaska and its economy.

 


  1. Joe McGinnis, in his The Rogue: Searching for the Real Sarah Palin, describes The Quitter’s reaction when a friend offered Palin, a new Wasilla City Council member, an intro to economics text. 
  2. Warning to real economists reading this post. Gross oversimplifications follow. 
  3. Yes, there is a similar formula for the effect of an increase in taxes. But inherently, at modest rates of taxation, the benefits of increased government spending outweigh the negatives of increased taxes. The evidence is in the other 49 states, all of whom have economies in better shape than Alaska’s and all of who impose taxes. 
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