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Does government spending help the economy?

Posted by Jeff (ILoveCapitalism) at 3:15 am - August 26, 2012.
Filed under: Big Government Follies,Economy

Dan asked last Saturday, Did government spending make recovery the slowest since WWII?. Put more broadly, does government spending help the economy or slow it down?

It’s a crucial question. If you believe (as neo-Keynesian economists try to teach) that government spending stimulates the economy, obviously we need more of it, because Obama’s economy is darn anemic. But what if more spending is unnecessary, perhaps harmful? What if government spending is one of the things dragging the economy down?

Arthur Laffer addressed this question in a Wall Street Journal piece a couple of weeks ago, The Real ‘Stimulus’ Record. His piece is not without flaws, but it says a lot that’s worth considering.

As Laffer notes, the U.S. has done a lot of ‘stimulating’ in the past few years, under both Bush and Obama:

Federal government spending as a share of GDP rose to a high of 27.3% in 2009 from 21.4% in late 2007… including add-ons to the agricultural and housing bills in 2007, the $600 per capita tax rebate in 2008, the TARP and Fannie Mae and Freddie Mac bailouts, “cash for clunkers,” additional mortgage relief subsidies and, of course, President Obama’s $860 billion stimulus plan that promised to deliver unemployment rates below 6% by now. Stimulus spending over the past five years totaled more than $4 trillion.

Think about that; an extra $4 trillion of national debt, in the name of ‘stimulating’ the economy. Has it worked? Can it work? Laffer gives some logical reasons why it can’t work:

…government [spending] takes additional resources… from one group of people (usually the people who produced the resources) and then gives those resources to another group of people (often to non-workers and non-producers).

Often as not, the qualification for receiving stimulus funds is the absence of work or income—such as banks and companies that fail, solar energy companies that can’t make it on their own, unemployment benefits and the like. Quite simply, government [is] taxing people more who work and then giving more money to people who don’t work…

Let’s see. Taxing (thus punishing) work, to pay for non-work; taxing production, to pay for non-production. Only a trained Keynesian economist could expect that to boost an economy.

…politicians and many economists believe [that] additional government spending adds to aggregate demand. You’d think that single-entry accounting were the God’s truth and that, for the government at least, every check written has no offsetting debit.

Well, the truth is that government spending does come with debits. For every additional government dollar spent there is an additional private dollar taken. All the stimulus to the spending recipients is matched on a dollar-for-dollar basis every minute of every day by a depressant placed on the people who pay for these transfers. Or as a student of the dismal science might say, the total income effects of additional government spending always sum to zero.

To be precise, every dollar of government spending is financed either by taxes, or government borrowing. Strictly speaking, government borrowing need not take dollars out of the economy IF the central bank (our Federal Reserve) is making lots of new dollars – and it has been.

But the new dollars are themselves an indirect tax. They dilute existing dollars. They transfer the purchasing power that people have stored in their savings and balance sheets, to the first recipients of the new dollars; in this case, the government. In the end, there is no net addition to purchasing power (or what Keynesians call “aggregate demand”). Laffer is right, the effects sum to zero.

Keynesian-trained economists talk endlessly about a “multiplier effect”: how a government stimulus dollar supposedly travels around the economy, creating wonderful activity as it goes. But they ignore the counter-acting, negative effects of “stimulus”: the loss of activity from taxes; or, if the government borrows the money, then the depressing effects of added government debt, and the destruction of real capital and real purchasing power from the eventual money-printing.

Some research has indicated that, if the Keynesian multiplier effect exists at all, it is short-term and works only for low-debt countries. As a country becomes more indebted, its bad balance sheet depresses its entrepreneurs, who know they are looking at higher future taxes (and/or money-printing). As a country proceeds with taxes and/or money-printing (which raises input prices), its entrepreneurs get even more depressed. In short, the multiplier decays, as a country becomes more indebted. In the end, the books must balance. “There is no free lunch.”

Looking at the stimulus programs that the world’s many debt-ridden countries have tried in recent years, Laffer concludes:

Sorry, Keynesians. There was no discernible two or three dollar multiplier effect from every dollar the government spent and borrowed. In reality, every dollar of public-sector spending on stimulus simply wiped out a dollar of private investment and output, resulting in an overall decline in GDP. This is an even more astonishing result because government spending is counted in official GDP numbers. In other words, the spending was more like a valium for lethargic economies than a stimulant.

But this brings me to my chief criticism of Laffer’s article. He has a table showing that, in country after country, escalating government spending coincided with declining GDP growth. Unfortunately, either the table is not very clear (not enough for me to understand), or it fails to show a causal effect: it appears only to show a correlation, from which one may fairly infer, at the most, that government spending does not reliably stimulate an economy.

That aside, the article says much that Obama and other big spenders would do well to reflect upon, before they blow the next $4 trillion on so-called “stimulus”.



  1. The financial crisis was caused by “constructive, collaborative ways that the government can work with private enterprise”: the Federal Reserve’s central planners forcing interest rates down to 1%, Fannie Mae and Freddie Mac securitizing subprime mortgages on a massive scale, and government regulators telling the banks that they will be punished as racist if they don’t lower their standards and do those mortgages.

    Comment by ILoveCapitalism — August 30, 2012 @ 11:39 am - August 30, 2012

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