Government Acquires the Money It Pumps into the Economy from Taxing or Borrowing (Excerpt)

Why Government Spending Does Not End Recessions

January 8, 2010

Heritage Foundation - Moving forward, 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.

Answering the Critics
 
Despite the foregoing evidence, some analysts maintain that governments can spend their way out of recession. Their common objections are addressed below:

Critics' Objection No. 1: People Are Saving Instead of Spending, and Banks Are Not Lending.

By borrowing and spending these "idle savings," government can circulate more money through the economy. This is the most common defense of government stimulus cited by policymakers. Indeed, among proponents of government spending there is a strong focus on whether people are spending or saving, with the implication that spending circulates through the economy while savings effectively drop out.

But savings do not drop out of the economy. Nearly all people put their savings in: (1) banks, which quickly lend the money to others to spend; (2) investments in stocks and bonds; or (3) personal debt reduction. In each of these situations, the financial system transfers one person's savings to someone else who can spend it. So all money is quickly spent regardless of whether it was initially consumed or saved. The only savings that drop out of the economy are those hoarded in mattresses and safes.

Some contend that recession-weary banks are hoarding savings well beyond the legal minimum reserves. Yet even when banks hesitate to lend their deposits, they invest them in Treasury bills to keep them circulating through the economy and earning interest. In fact, the federal funds market--where banks lend each other any excess cash at the end of the day--exists because banks refuse to sit on unused cash even overnight. Thus, even in recessions, one person's savings quickly finances another person's spending.

Advocates of the "idle savings" theory fail to specify the location of all these newly hoarded piles of dollar bills they believe have been shielded from spending in the financial system. Even more telling, they also fail to explain--even if there were massive amounts of idle savings--how the federal government is supposed to acquire them for injection as new spending. After all, even if individuals, businesses, and banks were hoarding dollar bills in mattresses and safes, why would they suddenly lend them to the government to finance a stimulus bill? The very idea of hoarding dollars suggests these people and businesses would not trust the financial system, and would be quite unlikely to attend the next Treasury bill auction.

Stimulus spending advocates must be able to show that nearly all money lent to Washington would have otherwise sat idle in mattresses and bank safes. Otherwise, Washington is merely a middleman transferring purchasing power from one part of the economy to another--and the justification for government spending as stimulus collapses.

Critics' Objection No. 2: Borrowing from Foreign Nations Can Provide "New" Money for the Economy. 

Accepting that domestic borrowing is no free lunch, some analysts have asserted that foreign borrowing can inject new dollars into the economy. However, these nations must acquire American dollars before they can lend them back to Washington. Foreign countries can acquire American dollars by either:

Attracting American investments in their country. In that instance, the dollars leaving America match the dollars lent back to America. The net flow of saving circulating through the U.S. economy does not increase.

Selling goods and services to Americans and receiving American dollars in return. For the United States, these imports raise the trade deficit and thus reduce domestic demand. The government's subsequent borrowing back and spending of these dollars merely offsets the increased trade deficit.

In either situation, American dollars must first leave the country before they can be lent back into the U.S. economy. The balance of payments between America and other nations must net zero. Consequently, government spending funded from foreign borrowing does not provide stimulus.

Critics' Objection No. 3: Government Spending Has a Multiplier Effect That Allows the Money to Re-circulate Through the Economy Multiple Times. 

This point is correct but irrelevant to the question of stimulus. Yes, $100 in unemployment benefits can be spent at a grocery store, which, in turn, can use that $100 to pay salaries and support other jobs. The total amount of additional economic activity will be well above $100; but because government borrows the $100, that same money is now unavailable to the private sector--which would have spent the same $100 with the same multiplier effect.

Consider a more comprehensive example. A family might normally put its $10,000 savings in a CD at the local bank. The bank would then lend that $10,000 to the local hardware store, which would then recycle that spending around the town, supporting local jobs. Suppose that the family instead buys a $10,000 government bond that funds the stimulus bill. Washington spends that $10,000 in a different town, supporting jobs there instead. The stimulus has not created new spending, jobs, or a multiplier effect. It has merely moved them to a new town.

The mistaken view of fiscal stimulus persists because people can easily observe the factories and people put to work with government funds. By contrast, people cannot easily observe the jobs that would have been created or factories used elsewhere in the economy with those same dollars had they not been lent to Washington.

In his 1848 essay, "What Is Seen and What Is Not Seen," French economist Frederic Bastiat termed this the "broken-window fallacy," a reference to a local myth that breaking windows would stimulate the economy by creating window-repair jobs. In reality, the window-repair spending comes out of funds that otherwise would have been spent (and created jobs) elsewhere in town. Today, the broken-windows fallacy explains why thousands of new stimulus jobs are not improving the total employment picture.

Critics' Objection No. 4: During a Recession, Government Spending Can Put Unused Resources to Work.

This restates the overall spending fallacy. Yes, government spending can put under-utilized factories and individuals to work--but only by idling other resources in whatever part of the economy supplied the funds. If adding $1 billion would create 40,000 jobs in one depressed part of the economy, then losing $1 billion will cost roughly the same number of jobs in whatever part of the economy supplied Washington with the funds. It is a zero-sum transfer regardless of whether the unemployment rate is 5 percent or 50 percent.

Critics' Objection No. 5: Government Reports Show That the Stimulus Has Already Created or Saved 640,000 New Jobs.

According to a White House survey, businesses have used much of the $200 billion in stimulus dollars distributed thus far to hire or retain 640,000 workers. These figures have been ridiculed for their absurdity, such as reporting $6.4 billion spent in congressional districts that do not exist, and the survey's assertion that a single lawnmower purchase in Arkansas saved or created 50 jobs.

Setting aside these inaccuracies, this jobs figure is not surprising. Businesses that receive large government grants would be expected to expand and hire more workers. However, this ignores half of the equation. If injecting $200 billion into the economy supports 640,000 jobs, how many jobs were first lost by borrowing that $200 billion from the economy?

The White House says zero. The White House job numbers assume that all $200 billion is new and supports jobs that would not otherwise exist. But that could be true only if the private sector would have otherwise hoarded the entire $200 billion in safes and mattresses, where it could not be consumed, invested, or deposited in banks for investment spending--but instead turned the entire $200 billion over to the government.

When dollars are transferred from one part of the economy to another, jobs will transfer accordingly. The White House's single-entry bookkeeping ignores the part of the economy that financed all these jobs. Not surprisingly, the nation's overall unemployment rate has continued to rise.

Critics' Objection No. 6: Government Should Subsidize Consumption, Which Represents 60 Percent of the Economy. 

This confuses the creation of income with its application. All income is applied somewhere in the economy: most on private consumption, some on private investment (converted from savings via the financial system), and some by government (taxed or borrowed out of consumption and investment). In the short run, the distribution of spending does not affect the total amount spent. The only way to increase consumption spending immediately is to take it from investment or government spending.

Declining consumption means that either: (A) more income is diverted into investment or government spending (which is zero-sum in the short run); or (B) less income is created overall, which typically leads to less spending across all categories. For the latter situation, the solution is to create incentives for productivity that create more wealth and income for people to spend across all categories.