Friday, February 14, 2014

Why Government Spending Stimulates

Four years ago, the conservative-leaning Heritage Foundation published a report asserting that fiscal stimulus—increasing government expenditures to fight a recession—could never work because government cannot increase output or employment.  While this argument has been refuted time and time again, it remains something that everyone on the right, including my colleague David Weinberger, just “knows” to be true.  But this argument is wrong, and it’s important to understand why.

The argument in favor of fiscal stimulus goes something like this.  In a depressed economy, there are “idle resources”—unemployed labor, factories and machines that aren’t being used, etc.  If the private sector is unwilling to utilize those resources, then government should do so by investing in things like roads and bridges, even if that means borrowing money to finance those investments.  As a result, total employment and income will rise, alleviating the effects of the economic downturn.


Now, you might argue, as Heritage does, that when government borrows money, it does so by drawing upon the private sector’s stash of savings.  Since the private sector is currently utilizing those savings to fund current economic investment—e.g., machines, factories, software—it must idle these resources to make funds available to the government.  After all, the argument goes, Washington can spend $1 million putting to work an idle factory in Michigan, but first must borrow that $1 million from Toledo (or wherever), which will cause the equal idling of resources there.  That means fiscal stimulus is always and everywhere a zero-sum game: total employment and income can never be augmented. 

Most economists recognize the fallacy in this argument: total investment determines total saving, not the other way around.  What does this mean, and how does this prove Heritage wrong?

The basic answer is, there’s no need for government to draw upon the existing flow of savings in order to build bridges and roads.  Government spends money first, then finances its expenditure later by selling Treasury Bonds.  This means that, in a depressed economy, there is no necessary and automatic equal reduction in economic investment when government deficit spends.  It works like this.

When the government deficit spends, the effect is that it adds more money to the private sector by purchasing things, like bridges and roads, than it removes through taxes.  Initially, this means there is a surplus of money in the private sector.   But then the government sells Treasury Bonds, which are purchased by investors, reducing that surplus back down to its original amount: private investors buy Treasury Bonds and give the government money in exchange.  So the overall impact on the amount of money available in the economy is zero.

Heritage’s mistake is to confuse the concept of money—cash, checking deposits, financial investments, etc.—in the economy with the concept of income—the total value of goods and services in an economy bought and sold over a given period of time.  Since, as we just saw, the overall impact of deficit spending on an economy in terms of money is zero, Heritage reasons, the overall impact on income must also be zero. 

But the government just invested in building a bunch of bridges and roads, don’t they have any value?  And if so, shouldn’t they be considered additional income?  Yes, they should.  When the government comes to the private sector and asks it to build a bridge, the private sector has two options.  It can either increase production and employment to manufacture the parts needed to fulfill the government’s order, or it can run down its existing stock of inventory.  Either way, production increases, and at the end of the day, the economy gets a bridge.  Total income, the value of all goods and services produced in the economy, has gone up. 

Another, albeit less important, error Heritage makes involves the process by which government finances its expenditures.  Heritage would have you believe that before the government can purchase a road or a bridge, it must first raise the funds necessary to finance those projects by selling Treasury Bonds.  Economists call this a “cash-in-advance constraint.”  But the U.S. federal government, as the monopoly issuer of the U.S. dollar, doesn’t have this problem.

Does this mean there aren’t any good arguments against fiscal stimulus?  Of course there are.  But asserting that economic theory dooms fiscal stimulus to failure represents a fundamental misunderstanding of how economics, and more specifically the monetary system, works. 

So the next time someone tells you they don’t support fiscal stimulus to fight a recession, you should ask them why not.  They may complain about the evils of budget deficits or say that the government wastes economic resources.  But if they say it’s because fiscal stimulus is a zero-sum game, you can politely explain to them why they’re wrong.

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