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  • The Fallacy of Stimulus Spending

    Everyone in Washington seems to agree that a huge package of “stimulus spending” will get the economy back on track to prosperity. The problem with stimulus spending is that the government has to get the money from somewhere. Every dollar the government spends has to come from either taxing or borrowing, or deliberately causing inflation.

    One might be tempted to conclude that there is a finite supply of wealth, and government can divide up the pie in different ways, but can’t make it any bigger. This is of course not true. The right policies can induce economic growth – but government spending cannot. Economic expansion can be achieved by increasing total production, but not by moving it around. For the economy to expand, entrepreneurial individuals and companies have to find it worthwhile to engage in productive activity and investment.

    Rather than producing free, effortless prosperity, “stimulus spending” is to economics what a “perpetual motion machine” is to physics. If you look at one part of the machine and ignore the rest, it can look like it’s giving you something for nothing. But when you look at the whole picture, it’s actually wasting energy, leaving you worse off than before, due to friction or some other source of thermodynamic inefficiency.

    If they tax to get the money, the dollar they spend is a dollar some taxpayer couldn’t spend (since she had to pay the taxes), so the increase in government spending is cancelled out by a decrease in private spending. So, there’s no actual “stimulus.”

    If they borrow to get they money, the dollar they spend is a dollar that wasn’t available for someone else to borrow (to buy a car, build a factory, whatever). So, the increase in government spending is cancelled out by a decrease in private spending. So, there’s no actual “stimulus.”

    They could also simply “print money” (it’s actually electronic nowadays). This is harder to explain but the effect is the same. there’s more money chasing the same amount of goods, so prices go up (“inflation”) and the dollars are worth less — by the exact proportion that they “printed.” So people spend more “dollars” but they can’t actually buy more stuff, since prices are higher. Money itself doesn’t really matter — it’s the stuff you can buy with it. And with the same money you can buy less. So the increase in government spending is cancelled out by a decrease in the purchasing power of all the money in circulation, so there’s still no actual stimulus.

    Every dollar the government spends is a dollar someone else did not spend. So there is no stimulus. But it’s actually worse than that, because taxation, borrowing, or inflation is itself costly. They distort incentives complicate business and personal financial planning — so the spending reduction by taxpayers, etc., is actually MORE than the amount spent by the government. It’s like friction. Some wealth just disappears, and we actually end up worse off than when we started. If we weren’t going to have a recession, all this “stimulus spending” might well create one!

    Harvard economist Robert J. Barro has estimated that the “multiplier” for peacetime government spending – that is, the proportion of government spending that goes toward increased GDP – is nearly zero. That is, every dollar’s worth of production used to satisfy the government’s demand for public works is offset by a dollar’s worth of production that is no longer available to consumers and businesses.

    Brian Riedl, in his paper, “Why Government Spending Does Not Stimulate Economic Growth,” summarizes the results of several studies that find that past increases in government spending have reduced the economic growth rate by between 0.14 and 0.36 percentage points. That may not sound like much, but it’s 10% of our historic average growth rate, and in times like these could easily mean the difference between a mild boom and deep recession. Is this long-term loss offset by short-term gains that might help during a short recession? No; “massive spending hikes in the 1930s, 1960s, and 1970s all failed to increase economic growth rates. Yet in the 1980s and 1990s—when the federal government shrank by one-fifth as a percentage of gross domestic product (GDP)—the U.S. economy enjoyed its great­est expansion to date.”

    The only way government can induce sustainable economic expansion is to reduce the taxes and regulations that inhibit productive activity. This does not mean, as Sen. Baucus has recently proposed, simply giving favored industries – or even everyone – tax credits of some number of dollars. That will not increase the incentives for productive activity, and in effect are no different from government spending.

    What is necessary is a change in the returns to work and investment — for example, a reduction in the tax rate faced by workers and investors. If the government gives you a $500 or $5000 tax credit or rebate, there is no incentive to change your behavior. But if the government reduces your (for example) income tax rate from 10% to 5% or 33% to 28%, you are keeping more of what you earn – which means it’s more worth your trouble to earn it.

    Economist Alex Tabarrok has the clever idea of reducing everybody’s tax rate substantially – for all income above whatever they earned last year. This would have a strong stimulus impact – by encouraging people to work more hours, tax second jobs, or (re-)enter the labor force. This would increase production and induce economic expansion without any use of taxpayer funds, and without replacing one type of production with another.

    That’s the sort of creative ideas we need right now, rather than a repeat of the stimulus spending approach that has failed every time its been tried.

    Posted in Ongoing Priorities [slideshow_deploy]

    27 Responses to The Fallacy of Stimulus Spending

    1. Keith Taylor, DeWitt says:

      What is it going to take for people to realize that the stimulus package is not going to work. I live in an area made up of UAW people who think the people in power owe it to them even as the car sales etc. in Michigan drop each month. Not only that, we just went over 10% unemployement thanks to our great Michigan leader, in bed with the unions, who believes the only thing to save us is more taxes,state, local, and small business. She still can not figure out why everyone is leaving. You are right, drop the stimulus package, lower the tax rates, and for get them for three months. Of course that is the smart way?.

      Thanks,

      Keith Taylor

      DeWitt MI

    2. Matthew, Kentucky says:

      Problem is, these basic economic truths are not taught in the public schools, and the teacher's unions don't want them taught. Wasn't until college that I was exposed to the truth about things I'd always had hunches about. Lucky for me my years in public education were so boring I never was indoctrinated to the point others have been.

    3. Wayne from Jeremiah says:

      I've used a quote from your post on Has the Bailout Failed yet?

    4. A. M. Ekland says:

      This model is flawed; it only looks at the GDP and not the whole picture. Besides, if you only take care of the investment/industrialist class, there will be no one to buy the products no matter how motivated a CEO is to sell them. It's a proven fact that small businesses of under 50 employees are the biggest asset of employers. It is traditional for big box companies to either run on skeletal crews, part-time employment, or automated services. You can't keep squeezing the worker classes and expect them to somehow keep come up with the money to buy your goods; this defies common sense. As for the unions, they make the difference between fairness in the world and a myopic predatory class of self-indulgent hedonists. Look at what was done with the bailout money: Lavish trips to the spa, manicures, beluga caviar, massages, and "escort" services. This is a really vital use of US resources, to say nothing of all the golden parachutes. I hope the heyday of corruption is over. The whole world sighed a sigh of relief as GWB/Cheney were given the bum's rush out the back door. I hope Obama has the chutzpah to see the job through. I'm sorry Milton Friedman's parents ever met and double for Karl Rove. Face it, the days of milk and honey and unregulated Free (fall) trade are over. Maybe not under Obama, but most assuredly at the beginning of the next decade. The people are sick to retching of this sorry excuse for public looting in the name of "doing business". Say good-bye to Hollywood; the age of the gilded Lear jet is over and anyone who tries to resurrect it will be seen as a domestic enemy of the state.

    5. A. M. Ekland says:

      This model is flawed; it only looks at the GDP and not the whole picture. Besides, if you only take care of the investment/industrialist class, there will be no one to buy the products no matter how motivated a CEO is to sell them. It's a proven fact that small businesses of under 50 employees are the biggest asset of employers. It is traditional for big box companies to either run on skeletal crews, part-time employment, or automated services. You can't keep squeezing the worker classes and expect them to somehow keep coming up with the money to buy your goods; this defies common sense. As for the unions, they make the difference between fairness in the world and a myopic predatory class of self-indulgent hedonists. Look at what was done with the bailout money: Lavish trips to the spa, manicures, beluga caviar, massages, and "escort" services. This is a really vital use of US resources, to say nothing of all the golden parachutes. I hope the heyday of corruption is over. The whole world sighed a sigh of relief as GWB/Cheney were given the bum's rush out the back door. I hope Obama has the chutzpah to see the job through. I'm sorry Milton Friedman's parents ever met and double for Karl Rove. Face it, the days of milk and honey and unregulated Free (fall) trade are over. Maybe not under Obama, but most assuredly at the beginning of the next decade. The people are sick to retching of this sorry excuse for public looting in the name of "doing business". Say good-bye to Hollywood; the age of the gilded Lear jet is over and anyone who tries to resurrect it will be seen as a domestic enemy of the state.

    6. Spiritof76, New Hamp says:

      In the old days, doctors believed that blood must be drained from the patient to get rid of the malady. In many cases, the patient died as a result of the procedure and not due to the disease! That is what a government stimulus package will do to our economy- make it worse. A recession requires incentives for production and not re-allocation to inefficient centrally-planned projects.

    7. Jaime Rodriguez says:

      Thank you for the article on "The Fallacy of Stimulus Spending" it makes perfect sense to me. Why is it so hard for the present administration to comprehend?

    8. Mike, USA says:

      Where WERE you a few months ago when our government cooked up the scheme to hand ove 700 billion to the very same people in the banking system that ran their companies out of business? Handouts to business don't work either.

    9. Mike, USA says:

      "Economist Alex Tabarrok has the clever idea of reducing everybody’s tax rate substantially – for all income above whatever they earned last year. This would have a strong stimulus impact – by encouraging people to work more hours, tax second jobs, or (re-)enter the labor force. This would increase production and induce economic expansion without any use of taxpayer funds, and without replacing one type of production with another."

      To re-enter the labor force, one has to have a job to go to in the first place. You've oversimplified the USA's problems. We don't have competition from China, instead the Chinese government has blatant illegel (in WTO terms) manipulation of their currency, and huge government subsidies (also illegal in WTO terms).

      Simply reducing taxes across the board without reducing spending will obviously only increase the bloated debt. We also need our government to even the playing field to allow businesses to regroup here in the USA to provide good jobs, rather than running away to China and the far east. Im no proponent of subsidies here in the USA, it leads to incompetent and uncompetitive businesses. But we do need our government to even the playing field by forcing the Chinese Government to cleanup their very dirty act.

    10. gerald nesbitt says:

      just lower all tax rates by 5% and lower the

      capital gains tax by 10% for 2 years and lower

      lower business tax by 15% for 2 years and we

      would not have to spend any of the peoples money.

    11. val,houston,texas says:

      who do you think will end up paying for this stimulus b.s. us the public anytime gov't wants to spend more the taxpayers end up paying double.

    12. Ted, Atlanta, GA says:

      We've been in a life raft on the Atlantic Ocean for the last 3 days after our boat capsized and sunk.

      We're out of potible water- the group is getting desperate and thirsty.

      Obama is the captain of our ship. He's telling everyone to drink the salt water. It will make us feel better he says.

      "Just add a bit of this Kool-Aid to it. It will be fine!"

      The more government spends the less we have. We need to make the pie bigger, not cut it up into smaller pieces.

    13. Phil, Goldsboro, NC says:

      Your statements, 'Every dollar the government spends is a dollar someone else did not spend. So there is no stimulus.' seem at first glance to be true. But what if the dollar taken is from some rich person who has all he needs and the dollar given is to some person who can now buy the necessities he couldn't buy before? Admittedly that rich person is still presumably investing unless he has it in a sock at home and increased production can lead to more jobs but in a recession don't a lot of companies simply use the extra profit they get from lower profits to save up for a rainy day versus expand (i.e., the company has their own 'sock')? In that case, the increase of money in the private sector does not lead to an increase in the number of jobs. I'm really not criticizing here, I want to understand this issue better.

      I also wonder, didn't the Bible have a year of Jubilee when debts were cancelled and property returned to the original owners? Weren't there some 'socialistic' measures in place to ensure that the rich didn't just grow richer at the expense of the poor? Isn't it at least partially the job of government to ensure, as the Bible enjoins repeatedly throughout the Old Testament, that rich people don't exploit poor people? I detest frivolous wasteful government spending, but it's hard to feel good about, much less defend, the refusal to authorize taxation to give poor people the money they need to live. Again, please note, I know there are Medicaid abuses and I do not sanction them. I am simply wondering about this idea that using government money to help the really poor person is a poor decision economically. I am pretty sure that I'm wrong here, because many Christians whom I respect, hold this opinion, but would appreciate some enlightenment that is not overly technical.

    14. John Theobald, Marie says:

      The fallacy here is NOT whether "stimulus" spending by the Government is of any benefit. The article does a good job of exposing that shortcoming. Rather, the fallacy is in the "stimulus" package itself. It is, for all intents and purposes, a brutal and repressive miscarriage of Government perpetrated by unscrupulous "Representatives" and the Executive Branch. It is wrought with expanded spending on liberal programs that do nothing to benefit the economic situation. Rather, this abomination of Federal spending of BILLIONS of dollars on programs like "ADMINISTRATION FOR CHILDREN AND FAMILIES LOW-INCOME HOME ENERGY ASSISTANCE" and "PAYMENTS TO STATES FOR THE CHILD CARE AND DEVELOPMENT BLOCK GRANT" and "CHILDREN AND FAMILIES SERVICES PROGRAMS" and on and on are all a Trojan Horse designed to make the ignorant willingly welcome the great gift, only to find it is full of robbers, thieves, assassins, and all manner of nefarious types that are intent on destroying this Country from within.

      In short, the ONLY way to defeat them, is to never open the gates to them. Rather, let them bring this gift forward, and when it reaches our gates, let us cast hot oil and flames upon it and demonstrate our disdain for such "gifts".

      Thomas Jefferson said:

      “The principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale”

      and:

      “The spirit of resistance to government is so valuable on certain occasions that I wish it to be always kept alive.”

      Go read http://kithbridge.com/RecoveryBill01-15-09.pdf … see for yourself.

    15. Lee, New Orleans says:

      Giving to the poor is scriptual, but giving to the government so they can give to the poor is not. Giving to the government means that they are taking money from someone, possibly rich, possibly of meager means. A clear definition of rich was not defined exactly by our new President, it varied during the campaign. Now Congress has defined it in the new House bill, but the 'rich' are the people who hire other people, thereby increasing employment so they can earn a profit, not a bad thing. Although some Congressmen think it is and want to take all of it. That form of government is known as Socialism or Communism. According to Karl Marx, government should take from 'each according to his ability and provide for each according to his need'. Sounds good, like it should work, but it doesn't. In fact, it has been tried numerous times by countries throughout history and even to a certain extent, in our country. But, the Bible never required nor authorized Socialism, either. Giving to the poor should be voluntary, not mandatory. We already have overburdened entitlements to take care of the poor, unhealthy and older Americans. Congress has stolen that money we were supposed to have saved to pay for those programs and when many millions desire benefits and only a few million are working to pay for their benefits, our taxes will grow exhorbitantly. We've tried a form of Socialism during FDR's, Carter's and Nixon's and most recently in Bush's Presidency, with extremely unstable money by allowing a huge credit expansion encouraged by the government and with no reduction in governement spending. All it did was create a recession by creating a housing bubble and when it burst, taxpayers suffered and giveaway programs proliferated, making solving the problem much worse and causing many more bank and company failures and much more unemployment. If you take something from one citizen and give it to another citizen you are not increasing economic output. In fact the real economic impact is negative and never has been positive, even during WWII. That form of government also doesn't help the poor, but continues their dependence on a broken welfare system with no incentive to get out of it. Spreading the wealth comments by Joe the Plumber were accurate. The Obama plan is a gift of money to legislators to do what they want to with it. Why don't we call it the Obama-Pork Bill? Congressmen will make sure everybody gets a little piece of the pork-pie and try to make people think it is great. When it fails in a few years because taking money from Peter to pay Paul has never worked, they will say it wasn't big enough or we didn't have enough regulations to make sure it worked. What happened to spending money for what is authorized by the U.S. Constitution and trying to stimulate private investment with lower taxes for all citizens?

    16. Greg, Bay Area, CA says:

      A.M. Ekland, could you pass a little of whatever it is you've ben smoking? It's for folks like you that articles like this need to be written. And read. And understood.

      P.S. Your assessment of unions is naive. Take a look at any U.S. union's LM-1/2 filings for a peek at a hedonist class. The role of unions in the U.S. is pathetic and parasitic. Why oh why do you think that a raving socialist like Barney Frank supported a Detroit bailout? For the U.S. car-buyer? No, for the unions who opened up their wallets for Democratic candidates using the confiscated and misappropriated dues of their members.

    17. Marshall Hill-Michig says:

      Where are the keep it simple people,who can solve

      these very repetitive ailments, by looking at its

      History and past Solutions that have worked!

    18. Casey, Texas says:

      Phil,

      When you wrote, "I detest frivolous wasteful government spending, but it’s hard to feel good about, much less defend, the refusal to authorize taxation to give poor people the money they need to live". I think you have stumbled upon one of the great differences between conservatives and liberals. I do not believe the governments role is to "give" the money to poor people to live, at least not as far as the Constitution is concerned.

      Isn't there a fable somewhere that goes: "If you give a man a fish you feed him for a day, if you teach a man to fish, you feed him for life"? There will never be equality in wealth anywhere in the world in my opinion. You cannot take the bottom and raise them up to create equality, because some people simply won't be made better. They lack the motivation to do so, and giving them things only entrenches that behavior further. The only way one might attempt equality is to make everyone equally less. The current education system is a perfect example of that.

      To me it is not compassion to give someone just enough to get by, all the while promising more "gifts" to help them. That is modern day slavery. Those people and their thoughts are now bound to the person who controls the purse strings of their meager existence. They can now be manipulated by a politician who either promises more or tells them the other guy wants to take away what little they have. A person can get accustomed to almost any income level and stop pushing, striving and being productive. If I make just enough to get by and don't have to deal with work and all of the challenges related to it, why would I take a job making little more than I get for sitting at home? I am a very motivated person, but obviously not everyone is. How come we never get to 100% employment? Because there are just some people who aren't willing to expend the effort.

      Finally, if you look at charities and compare it to government, the amount of money spent to administer the funds is exponentially greater in government than in charities. If I give a dollar to charity, on avg. over 90 cents will get to the cause I believe in. On the other hand, if the government takes a dollar from me to give to the poor, less than 60 cents of it will get to the poor. This is not an efficient way to help people in need. The avg. US citizen gives more than twice as much to charity as the avg. EU citizen. If the government didn't TAKE those dollars, I have to believe based on the numbers that even more would be donated. Hope this helps.

    19. Mike Sheahen, Hickory, NC says:

      To see the diabolical government elitist fallacy of so-called “stimulus (government) spending”, consider, for example, the revealing inconsistency of the Left’s “Holy Man” of so-called “stimulus (government) spending”, J.M. Keynes (as in “Keynesian Economics”), in his having to somehow allow that such government spending is not a good idea, and is thus of course undesirable, yet he tried to make it miraculously become both a good idea and desirable in case of any so-called “economic downturn”, if government did such spending instead of anyone else.

      If such inconsistency doesn’t help expose the diabolical government elitist fallacy of so-called “(government) stimulus spending”, then considering how such spending is declared “immoral”, and even punished, including by government, as “a crime” when individuals, families, and businesses do it, and yet it’s lauded and even insisted upon as “the thing to do” when government does it, certainly should help expose the diabolical government elitist fallacy of it.

      Indeed when individuals and most businesses engage in such spending and accounting trickery, the only thing which beats them to bankruptcy and being hauled into court on criminal charges, and into prison, is the IRS to them, and the headlights on their ride to prison!

    20. Robert, UT says:

      How come we seem to be the only ones that understand that “stimulus packages” don’t work? Why doesn’t the government get it?

    21. Jamie Rio Martinez says:

      This bucket of pork will do nothing but drive our economy into a deeper hole. We cannot spend ourselves out of this problem.

      Cutting taxes will help. Let's start there.

    22. Barb -mn says:

      Robert,
      They must have been abused as children. Government dependents. They only comprehend the narrow minded thinking. Their parents must not have given them the upbringing of personal responsibilities so they take ours.

      It’s all a part of the agenda. And to add to the mix A GOVERNMENT SPENDING SPREE!

    23. Wayne Brackett, Alab says:

      Queen-Pelosi, King-Reed, Jester-Obama

      Even a half wit knows better than this!

    24. Jeanne Upset America says:

      How can anyone believe that our "government" is capable of fixing any of this mess? They are the ones that allowed it to happen. The politicans on the hill over the last 4-5 years allowed the lobbyist from the banking industry to persuade them to change or relax lending laws, etc. Why would the american citizens allow these people to have more control over what they messed up in the first place? Personally, I believe that if the Feds want to give away OUR hard earned money, they just need to give it to us legal, citizens. I believe an email stated that they could give every legal citizen in the US from the age of 18 to 75, $270,000.00 with what the Feds have "spent" trying to fix the meltdown. Now don't you think that giving us this kind of money would "STIMULATE THE ECONOMY?". People would pay their bills off, pay their mortgages off, buy new homes, buy new cars, TV's, go on vacation etc, etc. etc. This would stimulate the economy wouldn't it. The banks would have more money to loan since people would be catching up if not paying off their loans on their homes and cars or whatever..

      The government can't fix anything. They would throw the baby out with the dirty bath water if you didn't watch them. Remember folks, OUR GOVERNMENT IS THE REAL REASON WE ARE IN THIS MESS IN THE FIRST PLACE. Do you really think any of them can fix it. Heck it appears that a lot of them don't, won't or can't even pay their own taxes. Doesn't this wake you people up? Now next on the democrats agenda is trying to "steal the fifth amendment" and to control what and who gets to talk on the radio and tv's. Heaven help us all!!

    25. Angry Dumbo says:

      They never learn.

    26. David, in Florida says:

      I've got an answer for you and will send once I get it written for people to understand. The U.S. Government is doing this on purpose. They work trade agreements with other Countries and since the U.S. dollar is the Worlds most widely traded currency, they will print more of it and bully other nations to invest in the U.S. Treasury. They cut deals. You put so many billion in my Country's Treasury, I'll allow unfair trade with your country to sell products to our citizens.

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