Sunday, March 2, 2014

Striking Out on Stimulus

Yesterday, David wrote a post attempting to explain why the government’s $800 billion stimulus “failed.” The point of David’s piece was to prove that not only was stimulus an empirical failure, but also a theoretical one. Reasonable people can disagree on whether the stimulus was an empirical success. But what should be clear is that economic theory does, in fact, suggest that it can work.

Yet David argues that “The only way government can spend a dollar into the economy is by removing a dollar from the economy, meaning spending is a zero-sum transfer of resources.”

I pre-empted this argument, and many of David’s other points, already in the blog post “Why Government Spending Stimulates.” That piece showed how David was incorrectly equating the concepts of money and income by assuming that because there is a zero-sum transfer of money when the government deficit spends, there must also be a zero-sum transfer of economic resources. But David remains unconvinced, so let me try this again.

The centerpiece of David’s argument is that “all money in an economy is applied toward economic activity. Therefore, removing dollars destroys economic activity that would otherwise take place.”

Let’s break this down into two pieces. First, is it true that all money is applied somewhere?

No, it isn’t. This continues to confuse the concepts of money and income. I suppose the confusion stems from the accounting identity in economics that says that the total amount of income in an economy—the value of goods and services bought and sold over a given period of time—must be equal to the total amount of spending. That is, all income in an economy is spent. As the Babysitting Co-op story illustrates, this makes sense because my spending is your income and your spending is my income.

Of course, that’s not the same thing as measuring the volume of money in the economy and claiming it’s all being spent on newly produced goods and services, like David tries to do. The Federal Reserve estimates that there’s about $1.25 trillion worth of currency in circulation. How much of that is sitting in ATMs, in the hands of foreigners, being held as travelers checks, or in peoples’ wallets or checking accounts, etc. is anyone’s guess. But one thing’s for certain: all of it isn’t constantly being used to finance currently produced goods and services.

How about David’s second premise, that removing dollars from the private sector destroys economic activity that would otherwise take place? As I showed in my initial post, this relies on the idea that the government removes dollars from the private sector in the first place, but it doesn't. So this premise fails on its own merits.

One way to see the falsity of David’s claim is to imagine an economy that has no money, just economic resources such as land, labor, machines, equipment, and technology. In a depressed economy, many of these resources are left unused. So if the government decides to build a bridge, there’s no reason the private sector needs to give up the economic resources it’s currently using—there’s already plenty of idle resources at the government’s disposal.

Adding money to this economy doesn’t change the aspect of the problem. If the government uses money to activate some of the unused resources, it doesn’t prevent the private sector from using its money to continue putting its current economic resources to work. Again, stimulus--financed by Government debt--leaves the amount of money in an economy unchanged, so in no way inhibits the private sector’s purchasing power or its capacity to employ economic resources.

David’s post makes a big deal out of the question “where does the money come from?” But his argument obscures and mystifies what is really going on in terms of economic resources. The key economic question is not whether fiscal stimulus costs money or where it comes from, but rather, whether it costs economic resources. If the economy were actively employing all those resources, then David would be correct. But in a depressed economy, it’s not.

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