Why Government Spending Does Not Stimulate Economic Growth:
Answering the Critics And how taxes affect economic growth.
www.wsj.com
By BRIAN M. RIEDL
From the Heritage Foundation ________________________
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Proponents of President Barack Obama's $787 billion stimulus bill continue to insist that the massive government bailout played a decisive role in moving the economy out of the recession. Yet assuming no destructive government actions, the economy's self-correction mechanism was widely expected to move the economy out of recession in 2009 anyway. With a parade of "stimulus" bills the past two years (going back to President George W. Bush's tax rebate in early 2008), it was entirely predictable that some would link the expected end of the recession to whichever stimulus bill happened to come last.
Indeed, President Obama's stimulus bill failed by its own standards. In a January 2009 report, White House economists predicted that the stimulus bill would create (not merely save) 3.3 million net jobs by 2010. Since then, 3.5 million more net jobs have been lost, pushing the unemployment rate above 10 percent.[1] The fact that government failed to spend its way to prosperity is not an isolated incident:
• During the 1930s, New Deal lawmakers doubled federal spending--yet unemployment remained above 20 percent until World War II.
• Japan responded to a 1990 recession by passing 10 stimulus spending bills over 8 years (building the largest national debt in the industrialized world)--yet its economy remained stagnant.
• In 2001, President Bush responded to a recession by "injecting" tax rebates into the economy. The economy did not respond until two years later, when tax rate reductions were implemented.
• In 2008, President Bush tried to head off the current recession with another round of tax rebates. The recession continued to worsen.
• Now, the most recent $787 billion stimulus bill was intended to keep the unemployment rate from exceeding 8 percent. In November, it topped 10 percent.[2]
Undeterred by these repeated stimulus failures, President Obama is calling for yet another stimulus bill.[3] There is every reason to expect another round to fail as miserably as the past ones, and it would bury the nation deeper in debt.
The Stimulus Myth
The economic theory behind the stimulus builds on the work of John Maynard Keynes eight decades ago. It begins with the idea that an economic shock has left demand persistently and significantly below potential supply. As people stop spending money, businesses pull back production, and the ensuing vicious circle of falling demand and production shrinks the economy.
Keynesians believe that government spending can make up this shortfall in private demand. Their models assume that--in an underperforming economy--government spending adds money to the economy, taxes remove money from the economy, and so the increase in the budget deficit represents net new dollars injected. Therefore, it scarcely matters how the dollars are spent. Keynes is said to have famously asserted that a government program that pays people to dig and refill ditches would provide new income for those workers to spend and circulate through the economy, creating even more jobs and income.
The Keynesian argument also assumes that consumption spending adds to immediate economic growth while savings do not. By this reasoning, unemployment benefits, food stamps, and low-income tax rebates are among the most effective stimulus policies because of their likelihood to be consumed rather than saved.
Taking this analysis to its logical extreme, Mark Zandi of Economy.com has boiled down the government's influence on America's broad and diverse $14 trillion economy into a simple menu of stimulus policy options, whereby Congress can decide how much economic growth it wants and then pull the appropriate levers. Zandi asserts that for each dollar of new government spending: temporary food stamps adds $1.73 to the economy, extended unemployment benefits adds $1.63, increased infrastructure spending adds $1.59, and aid to state and local governments adds $1.38.[4] Jointly, these figures imply that, in a recession, a typical dollar in new deficit spending expands the economy by roughly $1.50. Over the past 40 years, this idea of government spending as stimulus has fallen out of favor among many economists. As this paper shows, it is contradicted both by empirical data and economic logic.
The Evidence Is In
Economic data contradict Keynesian stimulus theory. If deficits represented "new dollars" in the economy, the record $1.2 trillion in FY 2009 deficit spending that began in October 2008--well before the stimulus added $200 billion more[5]--would have already overheated the economy. Yet despite the historic 7 percent increase in GDP deficit spending over the previous year, the economy shrank by 2.3 percent in FY 2009.[6] To argue that deficits represent new money injected into the economy is to argue that the economy would have contracted by 9.3 percent without this "infusion" of added deficit spending (or even more, given the Keynesian multiplier effect that was supposed to further boost the impact). That is simply not plausible, and few if any economists have claimed otherwise.
And if the original $1.2 trillion in deficit spending failed to slow the economy's slide, there was no reason to believe that adding $200 billion more in 2009 deficit spending from the stimulus bill would suddenly do the trick. Proponents of yet another stimulus should answer the following questions: (1) If nearly $1.4 trillion budget deficits are not enough stimulus, how much is enough? (2) If Keynesian stimulus repeatedly fails, why still rely on the theory?
This is no longer a theoretical exercise. The idea that increased deficit spending can cure recessions has been tested repeatedly, and it has failed repeatedly. The economic models that assert that every $1 of deficit spending grows the economy by $1.50 cannot explain why $1.4 trillion in deficit spending did not create a $2.1 trillion explosion of new economic activity.
Why Government Spending Does Not End Recessions
Moving forward, the important question is why government spending fails to end recessions. Spending-stimulus advocates claim that Congress can "inject" new money into the economy, increasing demand and therefore production. This raises the obvious question: From where does the government acquire the money it pumps into the economy? Congress does not have a vault of money waiting to be distributed. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another.[7]
Congress cannot create new purchasing power out of thin air. If it funds new spending with taxes, it is simply redistributing existing purchasing power (while decreasing incentives to produce income and output). If Congress instead borrows the money from domestic investors, those investors will have that much less to invest or to spend in the private economy. If they borrow the money from foreigners, the balance of payments will adjust by equally raising net imports, leaving total demand and output unchanged. Every dollar Congress spends must first come from somewhere else.
For example, many lawmakers claim that every $1 billion in highway stimulus can create 47,576 new construction jobs. But Congress must first borrow that $1 billion from the private economy, which will then lose at least as many jobs.[8] Highway spending simply transfers jobs and income from one part of the economy to another. As Heritage Foundation economist Ronald Utt has explained, "The only way that $1 billion of new highway spending can create 47,576 new jobs is if the $1 billion appears out of nowhere as if it were manna from heaven."[9] This statement has been confirmed by the Department of Transportation[10] and the General Accounting Office (since renamed the Government Accountability Office),[11] yet lawmakers continue to base policy on this economic fallacy.
Removing water from one end of a swimming pool and pouring it in the other end will not raise the overall water level. Similarly, taking dollars from one part of the economy and distributing it to another part of the economy will not expand the economy.
University of Chicago economist John Cochrane adds that:
First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can't help us to build more of both. This form of "crowding out" is just accounting, and doesn't rest on any perceptions or behavioral assumptions.
Second, investment is "spending" every bit as much as is consumption. Keynesian fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather than save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.[12]
Government spending can affect long-term economic growth, both up and down. Economic growth is based on the growth of labor productivity and labor supply, which can be affected by how governments directly and indirectly influence the use of an economy's resources. However, increasing the economy's productivity rate--which often requires the application of new technology and resources-- can take many years or even decades to materialize. It is not short-term stimulus.[13]
In fact, large stimulus bills often reduce long-term productivity by transferring resources from the more productive private sector to the less productive government. The government rarely receives good value for the dollars it spends. However, stimulus bills provide politicians with the political justification to grant tax dollars to favored constituencies. By increasing the budget deficit, large stimulus bills eventually contribute to higher interest rates while dropping even more debt on future generations.
Answering the Critics
Despite the foregoing evidence, some analysts maintain that governments can spend their way out of recession. Their common objections are addressed below:
Critics' Objection No. 1: People Are Saving Instead of Spending, and Banks Are Not Lending.By Borrowing and Spending these "Idle Savings," Government Can Circulate More Money Through the Economy. This is the most common defense of government stimulus cited by policymakers. Indeed, among proponents of government spending there is a strong focus on whether people are spending or saving, with the implication that spending circulates through the economy while savings effectively drop out.
But savings do not drop out of the economy. Nearly all people put their savings in: (1) banks, which quickly lend the money to others to spend; (2) investments in stocks and bonds; or (3) personal debt reduction. In each of these situations, the financial system transfers one person's savings to someone else who can spend it. So all money is quickly spent regardless of whether it was initially consumed or saved. The only savings that drop out of the economy are those hoarded in mattresses and safes.
Some contend that recession-weary banks are hoarding savings well beyond the legal minimum reserves. Yet even when banks hesitate to lend their deposits, they invest them in Treasury bills to keep them circulating through the economy and earning interest.[14] In fact, the federal funds market--where banks lend each other any excess cash at the end of the day--exists because banks refuse to sit on unused cash even overnight. Thus, even in recessions, one person's savings quickly finances another person's spending.[15]
Advocates of the "idle savings" theory fail to specify the location of all these newly hoarded piles of dollar bills they believe have been shielded from spending in the financial system. Even more telling, they also fail to explain--even if there were massive amounts of idle savings--how the federal government is supposed to acquire them for injection as new spending. After all, even if individuals, businesses, and banks were hoarding dollar bills in mattresses and safes, why would they suddenly lend them to the government to finance a stimulus bill? The very idea of hoarding dollars suggests these people and businesses would not trust the financial system, and would be quite unlikely to attend the next Treasury bill auction.[16]