Myth: Government Spending 'Stimulates' the Economy
Whenever the economy stumbles, politicians and interest groups commonly argue that government spending should be increased. Based on a theory known as Keynesianism, this increase is supposed to boost economic performance. Yet the notion that bigger government leads to more growth is both theoretically unsound and empirically false.
This strange theory was first put forth back during the 1930s, when America was suffering from a deep downturn. An economist named John Maynard Keynes argued that the economy could be boosted if the government borrowed money and spent it. According to this Keynesian approach, this new spending would put money in people's pockets, and the recipients of the funds would then spend the money. This would, according to the theory, "prime the pump" as the money began circulating through the economy. The Keynesians also said that some tax cuts -- particularly lump-sum rebates -- could have the same impact since the purpose is to have the government borrow and somehow put the money in the hands of people who will spend it.
So is this the right recipe to boost a flagging economy? Keynesian theory sounds good, and it would be nice if it made sense, but it has a rather glaring logical fallacy. It overlooks the fact that, in the real world, government can't inject money into the economy without first taking money out of the economy. Put more bluntly, Keynesianism only looks at one-half of the equation. It conveniently ignores the fact that any money that the government puts in the economy's right pocket is money that is first removed from the economy's left pocket. As such, there is no increase in what Keynesians refer to as aggregate demand. The bottom line is that Keynesianism doesn't boost national income, it merely redistributes it.
The people who lend the money to government generally are not the same people who get money in their pockets because of the new spending or tax rebates, but that's not important. The Keynesian theory is based on the notion that there will be an increase in overall spending power, yet that clearly is not the case. Some advocates of this theory get a bit more creative and say that Keynesianism works because it increases consumer spending rather than the money sitting idle. But money that is unspent by consumers does not sit idle. It winds up in the banking system someplace and is used to finance investment spending. So-called stimulus programs, at best, shift how national income is used so that more gets consumed rather than invested, but at noted earlier, there is no increase in overall economic output.