Why Spending Won’t Stimulate

02/03/2010 11:15

by Brian Riedl
Issue 149 - February 3, 2010

1)The fallacy that government spending stimulates because it transfers funds from savers to spenders
2)The fallacy that foreign borrowing represents new dollars in an economy
3)The fallacy that government spending stimulates because of the multiplier effect
4)The fallacy that government spending can put unused resources to work during a recession
5)The fallacy that government stimulus spending has already created 640,000 jobs
6)The fallacy that government spending can grow the economy by propping up consumption.

The failure of the stimulus bill to create jobs or economic growth has become increasingly evident.

Over the past 2 years, the Heritage Foundation has written that the idea that government spending represents new dollars injected into the economy has been contradicted by both empirical evidence (if it were so, last year’s $1.4 trillion in deficit spending would have overheated the economy) and by economic logic (Congress must first borrow the funds out of the economy, so the effect is zero-sum).

Yet critics continue to assert that government spending CAN represent “new” spending and thereby create stimulus. 

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.

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. 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." This statement has been confirmed by the Department of Transportation and the General Accounting Office (since renamed the Government Accountability Office), 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.

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.

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

My new paper also answers the six most common charges by these critics:

1)The fallacy that government spending stimulates because it transfers funds from savers to spenders
2)The fallacy that foreign borrowing represents new dollars in an economy
3)The fallacy that government spending stimulates because of the multiplier effect
4)The fallacy that government spending can put unused resources to work during a recession
5)The fallacy that government stimulus spending has already created 640,000 jobs
6)The fallacy that government spending can grow the economy by propping up consumption.

Finally, this paper examines how spending and taxes can affect *long-run* economic growth rates, although the effect is almost always negative.  The better way to guarantee long-term growth is through lower tax rates, less government, and a more productive private sector.

Brian Riedl is Senior Policy Analyst and Grover Hermann Fellow in Federal Budgetary Affairs at The Heritage Foundation

The full study, “Why Government Spending Does Not Stimulate Economic Growth: Answering the Critics” can be found at https://www.heritage.org/Research/Economy/bg2354.cfm

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