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.
It is worth noting that government could finance new spending through inflation. Thankfully that option doesn't seem to be on the table since almost all politicians now realize that it would be foolish to mimic the disastrous policies of basket-case economies such as Argentina and Zimbabwe.
The real-world evidence also confirms that Keynesianism is a failure. Indeed, it was a failure even before Keynes published The General Theory in the mid-1930s. In his four years, Herbert Hoover was a poster-boy for big government. He increased taxes dramatically, including a boost in the top tax rate from 25 percent to 63 percent. He imposed harsh protectionist policies. He significantly increased intervention in private markets. Most important, at least from a Keynesian perspective, he boosted government spending by 47 percent in just four years. And he certainly had no problem financing that spending with debt. He entered office in 1929 when there was a surplus and he left office in 1933 with a deficit equaling 4.5 percent of GDP. Needless to say, Hoover's big-government Keynesian experiment was not very successful since growth went down and unemployment went up.
Unfortunately, other than being a bit more reasonable on trade, Roosevelt followed the same approach. The top tax rate was boosted to 79 percent and government intervention became more pervasive. Government spending, of course, skyrocketed -- rising by 106 percent between 1933 and 1940. This big-government approach didn't work for Roosevelt any better than it did for Hoover. Unemployment remained very high throughout the 1930s and overall output did not get back to the 1929 level until World War II.
Other Keynesian episodes generated similarly dismal results, though fortunately never as bad as the Great Depression. Gerald Ford did a Keynesian stimulus focused on tax rebates in the mid-1970s. The economy did not improve. But why would it? After all, borrowing money from one group and redistributing it to another group does nothing to increase economic output. Tax cuts only boost the economy if they reduce the tax penalty on work, saving, and investment -- i.e., lower tax rates, not gimmicks.
More recently, George W. Bush gave out so-called rebate checks in 2001 and 2008, yet there was no positive effect in either case. And Bush certainly was a big spender, yet that didn't work either. Not that this should be a big surprise. Surveys of the academic literature reveal that even left-wing international bureaucracies are producing research showing that bigger government hurts economic performance by misallocating national resources.
Japan's experience also shows the foolishness of Keynesianism. Throughout the 1990s, Japanese politicians tried to use so-called stimulus packages to jump-start a stagnant economy. But the only thing that went up was Japan's national debt, which more than doubled during the decade and now is far above even Italy when measured as a share of GDP. The economy, not surprisingly, remained stagnant.
If Keynesian spending doesn't make sense from a theoretical perspective, and also fails every time it is tried in the real world, why do politicians keep trying the same approach? Your guess is as good as mine, but the answer probably has something to do with the fact that politicians love to spend other people's money, and Keynesianism is a convenient rationale.