Monday, March 3, 2014

Why the Stimulus Failed, Part Two

I recently explained why government stimulus spending must fail. Tim contested my argument, but I will show why it stands.

The basic flaw with stimulus spending is that, in order to spend a dollar into the economy, government must remove a dollar from the economy, which renders spending a zero-sum transfer of resources.

Tim challenged these basics by asserting that not all money is contributing to economic activity, so utilizing “idle” dollars for government expenditure would avoid the zero-sum critique and raise national income. There are three reasons this is wrong.

First, all dollars contribute to economic activity. Why? Any dollar can be either spent on a good or service or saved. Either choice affects economic output equally. Spending the dollar contributes to gross domestic product (GDP). Saving the dollar allows a bank to loan it to someone else to spend—also contributing to GDP. When people are hesitant to spend and banks hesitant to loan and thus total savings increase, banks invest savings in T-bonds to earn interest. This channels savings toward someone who will spend them on goods or services, again equally contributing to GDP. We know this because interest accrues on dollars in financial markets, meaning no dollars—savings or otherwise—ever sit unused.

Second, let us, for the sake of argument, say that Tim is indeed correct that people are hoarding money in their wallets or in travelers checks, or that ATMs are sitting on mountains of unused cash. In order to avoid the zero-sum critique, one must argue that government could neatly target those unused dollars—convince hoarders to part with their dollars, for instance—in order to spend them to add to national income. Doubtful a hoarder would be so inclined, but how could anyone possibly know who would or would not lend money to the government in exchange for a T-bond?

Third, even if we grant the first two premises, there is yet another that stymies stimulus theory. Assuming there are dollars currently unused on economic activity that government could neatly soak up to spend, that ignores the purpose of those “unused” dollars. If people are hoarding dollars from the financial system, they are likely protecting themselves from what they perceive as current and future risks, not merely sitting on cash for no reason. Thus, even if government could mop up those dollars in order to deficit spend, it is equally soaking up people’s protective hedge. So, rather than inducing more private spending, deficit spending encourages more hoarding, to restock the initial hedge of savings that the government depleted. In other words, any increased economic activity brought about by government deficit spending is likely offset by an increase in hoarding, resulting in no net new economic activity. This is known as the broken window fallacy.

That is why stimulus spending always fails.

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