Carte Blanche: Government Spending Does Not Grow The Economy

Alejandro Barba

To rescue the U.S. economy from the 2008-2009 recession, the federal government spent nearly $1 trillion in a massive stimulus bill. The collapse of 2008 turned out to be an excellent opportunity for the Keynesians to prove that deficit spending is the medicine for a stagnant economy, putting idle resources to use and lowering unemployment. Before the stimulus bill was passed, unemployment stood at 8%, and the Romer economic team had proposed a $787 billion stimulus package as a sufficient cure. According to their estimates, without the stimulus package unemployment would continue to rise to 9%, but on the contrary, with their proposed government spending, unemployment would only fall from 8% and the economy would climb out of recession. Economist Robert Murphy often points out an interesting piece of rhetoric based on these projections. After a larger stimulus bill took effect, unemployment rose to 10%- a worse outcome than the Romer Economic Team warned would take effect without their magic spending package. So then how would a Keynesian respond to this embarrassing outcome? Paul Krugman wrote afterward in his New York Times column that this outcome simply proves that the recession was even worse than they thought and that therefore the stimulus package should have been even greater!

So what Murphy points out by citing this example is the rhetoric trap Krugman used to validate his economic beliefs. If the stimulus package met the predictions of the Keynesians exactly, he inevitably would have used this as proof that the policy works. As it turned out in reality, when the exact opposite happened, Krugman still used it as evidence that stimulus spending works. So if their predictions are validated, Krugman is right, and if their predictions are invalidated, Krugman is right. What a useful piece of rhetoric. In his column, he simply alleges that the stimulus package prevented unemployment from rising even higher than the negative predictions made in the event that the government did nothing. His reasoning means that the policy will be proven literally no matter what the outcome is.

This is an extremely important topic in U.S. politics with the likelihood of an upcoming recession. If the longest credit expansion in American history ends like every other credit expansion, then arguments for massive stimulus spending will resurface. The elite class of economists with long credentials will show complicated mathematical formulas that the public cannot understand, and dissenters will be cast away as unenlightened reactionaries. We will be told that the depression is permanent unless another trillion dollars can be borrowed to “spur” or “jumpstart” the economy, while the empire of bureaucrats will roll up their sleeves. Even more will be at stake this time with the already unsustainable debt of the federal government before the next round of stimulus. For a correct interpretation of the upcoming decade, the idea that government spending can grow the economy or create wealth must be destroyed.

The mainstream view of Keynesian stimulus spending tells a compelling story for students in their introductory economics courses. Economic models presenting aggregate demand are intellectually satisfying and appear as ultra-scientific. An explanation of the theory begins with the concept of the economic multiplier. “Don’t you understand that the spending of one becomes the income of another?” The more individuals spend, the more purchasing power is circulated throughout the economy, presented as Aggregate Demand (AD), which is the driver of growth. It is the purchasing power given to economic actors that creates demand and “spurs” the economy. If AD is lacking, like in a recession, the state can step in to accelerate spending itself, and therefore demand. The spending by the government becomes income for other individuals, who then spend it to become income yet again, and so on.

Once the economic multiplier is understood, it is recognized how government spending provides economic growth. But it especially provides growth during a recession period, with the plague of idle resources. Mainstream economic thought does not provide a consistent theory of the boom and bust cycle, with many viewing it as an inevitable feature of a free-market system. John Maynard Keynes simply explained the business cycle as “animal spirits.” What is often taken into account however are the “idle resources”, such as factories that are closed or not producing at full capacity, unfinished investment projects, or unemployed labor. It is concluded that the government can bring the economy back to full capacity with stimulus spending that makes use of these idle resources. Since the resources are idle, they assert that the government cannot be diverting resources from a more productive use in the private sector. In the midst of a recession, with rapid unemployment and closing business, who could argue otherwise?

Further support given to this narrative overtime is the social science culture of exonerating evidence above reason and theory. Any time an economy recovers after government stimulus spending, this is regarded as proof of the doctrine. This popular historical narrative has absorbed both of the largest recessions in U.S. history. The official story is that military spending on World War II forced resources back to use and allowed the economy to recover from the Great Depression, just as Obama-era stimulus package saved us from the Great Recession.

Like many fallacies, especially those in favor of an expanding state, this vision of government spending appears to make sense on the outside. Especially given the fact that the economy did eventually recover after the stimulus of 2009. However, when taking a closer look, the entire thought process can be broken down with logical errors that separate the good economists from the bad.

When we are condescendingly enlightened with the fact that spending becomes income of others, it would be excellent if the same intellectuals could apply this economic multiplier effect to wherever the money was before it was redistributed by the government. Although government spending sets in motion a chain of exchanges from the point of expenditure, it can only do this at the expense of the private sector. The Keynesians cite the multiplier like it is creating new wealth that would not otherwise be there, when government spending really just creates a new chain of business by canceling it elsewhere. In other words, they should apply the magic multiplier to money individuals own before the government absorbs it through various means. All methods a state can use to obtain resources for so-called stimulus must crowd out the private sector. Besides taxation being the most obvious, deficit spending simply absorbs resources from both the future and the present. Money that would be invested in private sector investment is redirected to Treasury Bonds in the present and subsequently paid back in the future through more taxation. Monetary stimulus, as a more manipulative method, creates the illusion of new wealth while absorbing resources from the private sector, canceling out purchasing power individuals would otherwise have had without inflation.

There is no method of government spending that does not absorb wealth from the private sector. The debate then reduces to whether public spending is more productive than private spending. However, if the debate is rewired here, the idea of the economic multiplier is already conceded as a variation of the Broken Window Fallacy. A broken window does not create new wealth just because we see the glazier receiving payment, just as government spending does not create new wealth because we see the results. In both of these scenarios, wealth can either be destroyed or shifted around an economy, but not expanded. Economists that fail to follow money backward in their logic and only focus on what is physically seen as a result of implemented policies will continue to fall for variations of the broken window fallacy forever.

Now, Keynesian theory may abandon the justification of the economic multiplier in the context of an expanding economy, but assert the popular notion that everything changes during a recession. In the midst of idle resources, it is asserted that government spending cannot crowd out the private sector. This is wrong because of both a lack of understanding of recessions and an incorrect view of saving. To understand the meaning of idle resources, it is important to understand why they exist in the first place. During the boom phase, the central bank is artificially expanding credit and therefore higher-order capital goods that cannot be sustained by the real economy, which leads to the inevitable bust. During the recession, resources are temporarily idle because the investment projects were mistakenly induced by artificially low interest rates. Malinvestments must be liquidated and restructured. If government spending puts these misallocated resources to use, they are not fixing the problem nor growing the economy. Rather, stimulus spending absorbs saving and slows down the reallocation of the private sector, replacing it with non-productivity.

A major error that helps justify the fallacy of government spending is the idea that capital goods are homogenous and can be quantified into units. If capital is homogenous, we would be able to ignore the variables of time structure, location, and many other infinite factors, and reduce all production goods into a simple number of units, or “K”, as mainstream economics does. This allows the ignorance of many significant factors of capital and fits the homogenized blob into the perfect mathematical formulas that appear to be objective science. This thought process cannot comprehend the misallocation of capital goods induced by manipulated interest rates, or for that matter the role interest rates and saving plays in regulating the structure of capital in a free market. Logically, if the government physically moved all farming equipment to Manhatten, the Keynesians would be unable to understand the slow down in the farming industry, because their units of capital and aggregate demand would remain the same in their models. The failure to recognize capital as heterogeneous and unquantifiable reduces economics to pseudoscientific jargon.

During the reallocation process prices often deflate and saving increases. This serves the function of naturally leaving loanable funds for a reallocated capital structure once malinvestments are liquidated. Part of the problem with Keynesianism and much of mainstream thought is the idea that saving does not serve a productive role in an economy. On the contrary, saving is the only means by which an economy can accumulate capital and increase in prosperity. Saving is not wealth deleted from the market, but resources that can now be invested to bring more consumption in the future. Government spending that reallocates saving in the private sector is not exempt from the broken window fallacy.

Lastly, false evidence must be refuted and correlation without coherent theory must be rejected. The idea that war can lift an economy to prosperity is the same as the broken window fallacy, except one window is one billion windows. Yet the official version of history says that the Great Depression was only ended when the government diverted massive amounts of resources into war machines to be destroyed as if destruction is equal to profit. Logically consistent theory would provide that government spending cannot contribute to economic growth, and correlations through history can be met with plenty of counterexamples. The Hoover and Roosevelt governments both ran massive deficits for more than a decade through the Great Depression with no results. After the war, when military spending was finally reduced and the federal budget was balanced under Truman, the private sector experienced the greatest year of growth in American history. Those in favor of stimulus often cherrypick positive evidence of their narrative and ignore counter evidence. Another event deleted from history is the recession of 1921 where GNP declined by 17% and unemployment grew to 12%, to which the government slashed spending and taxes and the recession was over by 1922.

Unfortunately, nobody knows about the recession of 1920 and will not be thinking about it after the next financial crisis. The rhetoric traps, like the one in Paul Krugman’s column from 2009, should be resisted by all means and countered with consistent reasoning and evidence. There is much more at stake for the next recession, and it must be emphasized that the level of debt and credit expansion is a complete experiment for America. The stimulus bills that will be proposed as a result of this recession will be no match for moderate attempts at fiscal restraint. They will require complete rejection of government as a legitimate device for growth and prosperity.