Why public spending does not stimulate the economy
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by Tyrsis
A common misconception is that increases in government spending will stimulate the economy. The logic offered to support this argument often describes how government spending will end up being paid as income to either business owners or workers, who will then spend a portion of that extra income, which will then become somebody else's income and so on, causing the money to cycle through the economy, and create a multiplier effect and hence creating wealth and stimulating the economy. There is nothing wrong with this logic, but it doesn't quite justify public spending.
It's easy to see the multiplier effect in action as the government injects dollars into an economy. Our companies will make more sales, which encourages higher production schedules, encouraging employers to create more jobs. As a result, there will be higher levels of GDP and lower levels of unemployment. So what is there to complain about? There are hidden costs. Consider: where did that money come from?
It came from taxpayers. Taxpayers who would have used the money according to their own preferences and needs, directing the market to produce the goods and services that are the highest priority to these taxpayers. Additionally, these private spending patterns would cycle through the economy, like with government spending, creating the same benefits that government spending would. The difference, however, is that the economic activity spurred by private spending will signal the market to produce the goods and services that people actually need, rather than on what the government spends on behalf of the people.
Think about two possible ways that money can be spent:
1. Your money can be spent on yourself.
2. Someone else's money can be spent on someone else.
The first option is like most typical private spending habits. You spend your own money on yourself. Since you are spending your own money, you take care of how much you spend, keeping consideration of your limited resources. Additionally, since you are spending the money on yourself, you make sure you get goods and services that are important to you. Overall, this type of spending prevents waste, and guides the market to produce the goods and services that are important to society.
The second option is like most government expenditures. Someone else's money is being used on someone else. It's not your money (mainly), so you don't really care about how much you spend, and it's not being spent on you (mainly), so you don't really care what it's spent on either. This type of spending encourages waste, and haphazardly directs the market to produce goods and services that may not be beneficial to society.
So when government spends, it forgoes the opportunity of the far more efficient type of spending: private spending. Government spending joins the list of the many other "beneficial" programs where government intervenes, and unlocks steep hidden costs as an unintended consequence. It's not easy to envision the loss of government spending, as it improves GDP and lowers unemployment. However, private spending does it better, and by spending through the public treasury, we sacrifice the better option.
Tyrsis is a head professor of the economics department at the North American University.
If you are interested in writing editorials for Liberty and Prosperity, please contact our chief editor, Tyrsis. Topic submissions and newspaper subscriptions are also greatly encouraged. Thank you for your interest in Liberty and Prosperity.
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Comments
Solid article, as usual.
Another point - government doesn't really learn from their mistakes - they may spend billions of taxpayers' money on a failed program but will then turn around and throw billions at a similar program. They indulge in magical thinking - the assumption that THIS time the program will work.
Nice article, as expected 🙂
An additional worry is that, though the government will be quick to spend the cash (since, as stated, it is not their own money) they will have little to no incentive to spend it wisely or honestly since there is so little transparancy, responsibility, nor reprocussions if they mismanage it. And they will. That is the only certainty in all this.
why can't we just have lower income tax?
That is what would spark us better for that is the reason why we need a spark.
Voted ,and Subscribed.
Great article.
I have come to expect nothing less from you Tyrsis. This one delivers the truth in a way very hard to criticize.
Well done Professor. Thank you for sharing your wisdom on this matter. Voted and subscribed.
V + S... Great article!
It's a good article, and I understand your point. although, I have a question for you. It's not that big of a deal, but I think it would be fun to debate.
The eUSA government has been subsidizing the Hospital and DS industries (and it has to, only governments can purchase these things). But, we have a Q5 hospital already. We only really need one, as anyone can fight from there in any war we're involved in. Let's give a little more leeway, and say we "need" Q5s in our "key" border regions (Alaska, Florida, Texas, Hawaii) to make sure enough people live there and give it defense strength.
We also only need DSs in these border regions as well.
Now, why on earth do we have hospitals in regions such as Kansas or Colorado, neither of which are on the border nor hold key resources?
I say that the eUSA government is wasting money on Q1 Hospitals and Defense Systems all over the place. Buy better ones or don't buy one at all.
Now, bearing in mind how many people the construction industry employs, would you agree with the following statement?
"The eUSA Government must stop wasting taxpayer money on useless hospitals and instead put that money to better use."
Tyrsis, it's a well written article and an enjoyable piece to provoke discussion. My response isn't like the other responses though because I don't agree with your assessment. I really would like to write a longer response than what follows but a new semester is taking all of my time right now.
Simply, private spending cannot match the effect of government spending. The individual dispersion of money and thus spending cannot overcome the sum total. Infrastructure spending by government is among the most productive for an economy for the reasons that you mentioned (multiplicity and reducing unemployment). Take for example, the idea of $1 from or for each American. From each, let's say the total would be $9000. That can buy a hospital, which employs around 20 people, plus buys wood, which employs even more. On the other hand, give me $1 and I can't even cover the difference between Q1 and Q2 food. So in fact, the individual cannot stimulate the economy when the government can. Of course, this is just a hypothetical example that I've created to illustrate a circumstance that favors my point of view. Nevertheless, I believe it highlights my position.
The problem is that there are anecdotes of wasteful spending that one can point to that are indefensible like the Bridge to Nowhere. Only idiots actually claim that government just throws money at problems because this doesn't appreciate any economic principles, theories, or factual support. They are just spouting something they've heard someone else say one time.
I am sorry to say this, Lowell Kennedy, but there is nothing in your comment to make your position look stronger the Tyrsis's. My opinion of you is way lower now because you just contradicted yourself from one of your previous articles.
Nice 101 level article, as well as a quick debate starter. Of course, the issue is much more complicated for the advanced scholars of political economy.
Lowell, while I appreciate your Keynesian assessment, I'll respond with an Austrian one via Peter Schiff.
"Governments cannot create but merely redirect. When the government spends, the money has to come from somewhere. If the government doesn't have a surplus, then it must come from taxes. If taxes don't go up, then it must come from increased borrowing. If lenders won't lend, then it must come from the printing press, which is where all these bailouts are headed. But each additional dollar printed diminishes the value those already in circulation. Something cannot be effortlessly created from nothing.
Similarly, any jobs or other economic activity created by public-sector expansion merely comes at the expense of jobs lost in the private sector. And if the government chooses to save inefficient jobs in select private industries, more efficient jobs will be lost in others. As more factors of production come under government control, the more inefficient our entire economy becomes. Inefficiency lowers productivity, stifles competitiveness and lowers living standards."
Re: hospitals and defense systems (T.W.Caudillo)
You are right. Congress has already passed a bill in the forums which will no longer purchase low-quality hospitals and defense systems (deemed to be a waste of funds).
*
Lowell Kennedy, I don't believe that those discrete gaps between pricing and income are a problem, for we can simply look over a longer period of time, and the saved income will come into play then.
If the argument is that you can unlock multiplicity earlier (by the coerced pooling of these savings), then I suppose I have enough faith in the market to believe that such pooling can happen in the marketplace, without government coercion. It can be done in the form of investments. At the moment, there is no efficient (not really safe) way for private enterprise to unlock these gains, but at the same time, that means there is no way the government can do it any better either.
Also, I would like to add that this is not an argument to oppose all forms of government spending. The mention of hospitals and defense systems is a sobering thought to anyone who believes government spending needs to be reduced to zero. All I am saying is that the "generation of jobs and stimulus to the economy" is not a valid argument, when used alone, to justify government spending.
http://cato.org/pub_display.php?pub_id=9825
Quite enjoyable Prof. Tyrsis.
@Gilroy: I'm sorry I don't know the contradiction that you're talking about.
@Publius: I agree with the Austrian School on many points but keep in mind that they promote less regulation basically because they argue that the market and the factors related to the market are too complex to create a successful government-influenced economic model. I don't believe that is the case in eRepublik. In fact, the economics are very simplified.
@Tyrsis: I did not account for savings and that can minimize the differential that I discussed. The government can stay out the markets for markets to function (except hospitals and defense systems). However, I believe that the debate between us is whether or not they should. All prior evidence in eRepublik suggests that we should. That's part of the reason I wrote the article on the planned economy.
Perhaps there is justification for whatever government expenditures you are thinking of, but my point was that the "generation of jobs and stimulus to the economy" was not a valid argument.
I have not ruled out other justifications for government spending, and I can think of a few.
Good tyrsis, and everybody should know this. Another thing goverment spending causes is inflation, and a massive drop in currency value.
You can't simply pretend that Keynesian theory fails in this one article. Sorry.
Alby, I would instead ask you to consider becoming a Libertarian Party Member. One obvious reason is that you can run for Congress. Another reason is that "Federalists" do not necessarily uphold the libertarian values that I do (and you seem to).
ProggyPop, I am not pretending the Keynesian theory fails. However, I am pointing out a misapplication of the Keynesian theory.
I am applying Keynesian theory properly, by showing that Keynesian effects occur not only with government spending, but also with private spending. By doing so, I point out the irrelevancy of Keynesian theory to "generating jobs and boosting the economy". I demonstrate how the Keynesian multiplier effect applies to both government and private spending, but that the difference is that private spending creates more social utility!
Tyrsis:
You should mandate all your students to watch, "The Commanding Heights - The Battle For the World Economy"
http://www.pbs.org/wgbh/commandingheights/hi/story/index.html
For much of the 20th century, people blamed free-market capitalism for the ills of inflation, recession, depression, and mass unemployment. So governments everywhere sought to curb market forces and rein in their economies. The first to change direction were Ronald Reagan in America and Margaret Thatcher in Britain.
In the 1980s, markets were deregulated. State-owned industries were privatized. It was the start of a world revolution.
I didn't read it all, but it looks good.Voted.
I appreciate your look at government spending (with your economics background). I agree that government spending with corporations and direct economic support to corporations does not stimulate the economy (in a certain sense). I think we see that playing out on here and the real world.
As someone who "helps" run a multi-million dollar organization, I know that government spending with individuals does stimulate the economy (not big on theories since theories don't keep people employed or generate a bottom-line). In eRepublik and eUSA, government dollars back in the hands of individuals encourages consumption and stimulates growth (not in the artificial sense either). I also think consistent government spending with corporations helps stimulate the economy. I am not suggesting propping up businesses with government spending. Government is the largest employer (both directly and indirectly). It helps drive (or can kill) growth.
In the real world an economy with a flexible exchange rate would not benefit from fiscal allowances, no. Public spending will make the local rates rise, which makes the local currency stronger hence discouraging export which itself reduces the local rate until it's equal to global rates again. In other words it would only affect the composition of the GDP (more public spending, less net export), not raise it.
Borka, tisk tisk, no mention of RL here. You should be banned.😛
alby,
Tyrsis is kind of right when he says "Federalists" don't represent the values that you have. Federalists were followers of Alexander Hamilton who strongly favored national bank and gov't intervention.
"The problem is that there are anecdotes of wasteful spending that one can point to that are indefensible like the Bridge to Nowhere. Only idiots actually claim that government just throws money at problems because this doesn't appreciate any economic principles, theories, or factual support. They are just spouting something they've heard someone else say one time."
By saying that you obviously don't believe this - "The free market is just better than anything else."
Both of the quotes apply to RL and both are from you.
Those quotes aren't mutually exclusive. In fact, the second one is from Nave and is very Austrian in the context of the argument.
Additionally, don't forget that government doesn't employ anyone for a job with pay in game.
Peter D. Banko, although the government is the world's biggest employer, it does this at the expense of employment via private enterprise. When taxed, private spending decreases, lowering employment and GDP. This is then replaced with public spending.
The point of my article was that we are sacrificing the opportunity of the employment and growth via private spending that would have occurred had we not chosen to spend and tax. Because of the lack of incentives for government to use their money efficiently (explained in the article), we end up with a worse outcome, which is hidden away to those who have not noticed the invisible opportunity cost.
Borka Turbo, I believe that kind of "medium-run" analysis would be very applicable to eRepublik too!
"Additionally, don't forget that government doesn't employ anyone for a job with pay in game."
Never did - government spending spurs employment via their spending, as does private spending.
The difference is that private spending directs markets according to the voluntary action of individuals (which is what we assume is what they want the most with what they can afford), while public spending directs with an iron fist (which is arbitrary and has no particular method of being efficient).
The only possible exception to this that I could think of would be weapons. For two reasons:
1. The government is, in most cases, willing to spend more on higher quality weapons than individual soldiers would be.
2. Since the government receives the VAT taxes from any weapons purchases, they should, in theory, be willing to buy more, since they are buying at a lower real price.
Individuals don't only buy weapons, so a tax return composed of the forgone government expenditure on weapons would still boost the economy. Additionally, soldiers may not buy weapons because they expect the government to dish them out (as they do now). If this changed, soldiers may buy more (even in peacetime, in anticipation of higher prices during the war).
However, this is not to say governments shouldn't stockpile. There are merits to government stockpiling other than "generating jobs and GDP", and that may outweigh the benefits of letting individuals guide the market, since they don't necessarily know the likelihood of war as well as the government would.
Gilroy@
I do favor a central bank. I just favor it being used in a different fashion. And that being to keep a strong currency and wrestle economic power from the monthly elected government who's policies change with the wind.
If I happened to become President and was able to gain the support of the Congress, I would pass the Federal Reserve Act of 2009. That act would transfer all remaining cash and gold to the Federal Reserve Bank. I would then setup a Board of Governors, appointed by the President(s), and confirmed by the Congress, to oversee all monetary activity of the Central Bank with the dual mission of (a) Maintaining a Strong Currency relative to other nations and (b) keeping inflation low.
The number one enemy of the economy is government spending. So if the government is void of cash, they (MUST) rely on tax revenues in order to spend money. If they raise taxes too much, they'll be quickly unelected. Thus forcing fiscal disipline when the time comes for war, buying hospitals, defense systems, etc... At the same time the currency in the economy will be strong and power divided among skilled and powerful central bankers who have a revolving term limit that allows for economic policies time to grow and prosper.
But thats for another article... 🙂
Fun rating -1.
I am glad to see the economists enjoyed this article...
Tyrsis knows his stuff.
Governments cannot create but merely redirect. When the government spends....
Same is true for Laissez Faire. Trickle down assumes rationality on the part of the "haves". They save a LOT, don't spend it. Savings get injected back at best as investment, which is a lot less productive than consumer spending.
Solid article. Many people overlook the fact that the government's money is thier money. Definately a good read.
great article.
Smallwins@
I don't know if savings in eR has the same impact as in RL. The reason being is that in RL, saving deposits are used to fund lending. If you put $1.00 into a savings account, the bank will hold $0.10/cents on deposit and loan out $0.90/cents. Once all is said and done, that $1.00 deposit has created $10.00 of currency in the economy. And with banks lending to fund business growth, savings makes sense.
But in eR, savings only has the effect of reducing the currency supply in circulation. That has the impact of increasing the currency's valuation with the reduction in supply. This in turn will actually cause business growth to decline (ie: deflation). Too many goods/services/companies chasing too few dollars.