Fallacy: Government Spending and Deficits Stimulate the Economy
The following article originally appeared in Newsbusters Magazine here.
Fallacy: Government Spending and
Deficits Stimulate the Economy
An increase in government spending clearly benefits the individuals who receive the additional spending. Considered by itself, it looks as if the additional spending is a stimulus to the economy.
But that is hardly the end of the story. We have to ask where the government gets the money it spends. The government can get the money in only three ways: increased taxes; borrowing from the public; creating new money. Let us examine each of these in turn.
■ Additional taxation.
In this situation, the dollar cost to the persons who pay the taxes is exactly equal to the dollar gain to the persons who receive the spending. It looks like a washout.
Getting the extra taxes, however, requires raising the rate of taxation. As a result, the taxpayer gets to keep less of each dollar earned or received as a return on investment, which reduces his or her incentive to work and to save. The resulting reduction in effort or in savings is a hidden cost of the extra spending. Far from being a stimulus to the economy, extra spending financed through higher taxes is a drag on the economy.
This does not mean that the extra spending can never be justified. However, it can only be justified on the ground that the benefit to the people who receive the spending, or to the community from the activity to be financed by the spending, is greater than the direct harm to the taxpayers plus the hidden cost. It cannot be justified as a way to stimulate the overall economy.
■ Government spending financed by borrowing from the public.
Individuals who purchase the securities that finance the additional expenditure would have done something else with the money. If they had not purchased the government securities, they presumably would have purchased private securities that would have financed private investment. In other words, government spending crowds out private investment. At this level, it is again a washout: those who receive the extra government spending benefit, but the private investors, who are deprived of the same amount of funds, lose.
But again, that is too simple a story. The overall effect is an increase in the demand for loanable funds, which tends to raise interest rates. The rise in interest rates discourages private demand for funds to make way for the increased government demand. Thus, there is a hidden cost in the form of a lowered stock of productive capital and lower future income.
The Keynesian view that the spending is stimulative assumes that the funds the government borrows would not otherwise have been invested in the private capital market, but came simply from cash held in hoards by individuals from under the mattress, as it were. In addition, it assumes that there are unemployed resources that can readily be brought into the work force by activating the excess funds held by individuals, without raising prices or wages.
That is a possibility in some special cases, such as the Great Depression in the 1930s, when there had been a major reduction in total output and prices were very far from their equilibrium level. More generally, however, theory suggests and experience confirms that government spending financed by borrowing from the public does not provide a stimulus to the economy.
Japan provides a dramatic recent example. During the 1990s, the Japanese economy was depressed. The government tried repeated fiscals stimulus packages, each involving increases in government spending financed by borrowing. Yet — or maybe therefore — the Japanese economy remained depressed.
■ Government spending financed by creating new money.
In this case, there is no first-round private offset to the government spending. It looks as if it is clearly stimulative, and it is. The question is: What is doing the stimulating? Is it the government spending, which in the previous two cases was not stimulative? Or is it the increase in the quantity of money by which the government spending is financed?
Suppose the monetary authorities simply added to the money supply without any change in government spending. (They could do so by purchasing government securities on the market.) The additional demand for government securities would raise their price, which is equivalent to a reduction in the rate of interest. If the sellers of the securities simply put the new money under the mattress, that would end the story and there would be no stimulus. They are far more likely, however, to use the money for some alternative investment, or to spend on consumption. That would lead to exactly the same additional spending as using the money for government spending, but the extra spending would be in the private economy, not the public sector.
Digging deeper, the extra spending will initially be reflected in some combination of increased output and increased prices. The exact division will vary greatly from time to time, depending on the state of the economy and on whether the extra spending was or was not anticipated. If the initial situation were one of an economy roughly at its capacity level with reasonably full employment, a temporary stimulus to more production would be followed by a higher price level. After the price level had adjusted, the real economy would be back where it had started, unless there were further increases in money, setting off an inflationary spiral.
On the other hand, if the initial position were one of deep recession with unemployed resources, a much larger fraction of the increase in spending would be absorbed by an increase in employment and output, and a much smaller fraction by a rise in prices. Similarly, if the initial situation were one of incipient inflation, even the initial effect might be to produce inflation.
■ Confusion between monetary stimulus and fiscal stimulus.
The fallacy that government spending and deficits stimulate the economy has gained credibility because the extra spending is so often financed by creating new money. In that case, fiscal policy (changes in government spending and taxation) and monetary policy (changes in the quantity of money) are both in play and it is easy to attribute the effects of monetary policy to the effects of fiscal policy.
In order to get empirical evidence on the separate effects of fiscal and monetary policy, it is necessary to find episodes in which fiscal and monetary policy are moving in opposite directions, or one is neutral while the other is not. The example of Japan in the 1990s noted earlier is one such episode. In that case, monetary policy was repressive or at best neutral and fiscal stimuli programs were ineffective.
Over the course of years, I have studied a number of similar episodes both in the United States and around the world. In every case, fiscal policy intended to be expansionary was expansionary if and only if monetary policy was accommodating. This empirical evidence is consistent with the theoretical analysis of the preceding sections.
Other “myths” debunked in “Dollars and Nonsense”  include the myths that: economic growth causes inflation; tax cuts always cause a loss of revenue; deregulation hurts consumers; and the idea that economists can accurately predict the future.
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