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The Fallacy of Stimulus Spending

Posted By Robert Book On January 23, 2009 @ 4:34 pm In Ongoing Priorities | Comments Disabled

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 [1]. 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 [2] 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 [3],” 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 [4] 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.


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2009/01/23/the-fallacy-of-stimulus-spending/

URLs in this post:

[1] “stimulus spending” is to economics what a “perpetual motion machine” is to physics: http://www.amazon.com/Armchair-Economist-Economics-Everyday-Life/dp/0029177766

[2] has estimated: http://online.wsj.com/article/SB123258618204604599.html

[3] Why Government Spending Does Not Stimulate Economic Growth: http://www.heritage.org/Research/Budget/bg2208.cfm

[4] Alex Tabarrok: http://www.marginalrevolution.com/marginalrevolution/2008/02/a-real-stimulus.html

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