Saturday, March 1, 2014

Why the Stimulus Failed

The five year anniversary of the so-called “stimulus” marks an opportune time to reconsider why it failed to grow the economy.

Let us recall that in 2009 government spent monumental quantities—some $800 billion—in an effort to rejuvenate economic growth. Obama administration economists Jared Bernstein and Christina Romer reported that, with the stimulus spending, unemployment would not rise above 8 percent. Absent the spending, however, they alleged unemployment would reach upwards of 9 percent.

Despite these assurances, the herculean spending effort left the economy unmoved. Unemployment peaked well above 10 percent, and growth has remained vanishingly weak, particularly compared to historical post-recession standards. Yet the lack of real world success was as predictable as the theory is wanting.

The gist of stimulus theory is that, in an economy, one person’s spending is a second person’s income, and the second person’s spending is a third person’s income, and so on. During recessions people reduce spending and increase saving. When that happens, the circular flow of spending halts and economic activity and employment fall. In order to maintain that circular flow government should step in and fill that gap by deficit spending.

Behind this seemingly innocuous theory lies a glaring fallacy that puts a sword right through the heart of it. Government spending must be financed. 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. As my former colleague J.D. Foster put it, taking a dollar from your left pocket and putting it in your right pocket does not give you an additional dollar (for more on that, see here, here, here and here).

Offering a differing take on the subject, however, Tim argues that government spending can stimulate economic growth because government spends first and finances later, so as to avoid the zero-sum transfer of resources described above. Building roads and bridges first, he reasons, raises national income now; later, when government finances the projects by removing money from the economy, the value of the newly built infrastructure remains, and we are thus richer.

Yet this argument does not escape the fallacy. As my former colleague Brian Riedl stressed,  government cannot literally borrow money from the future. Economic resources that do not yet exist cannot be borrowed. Building a bridge today involves a zero-sum reallocation of resources today. So we are left asking the obvious question stimulus proponents must answer: from where does government acquire the money to spend first? Since government does not have a vault of money at its fingertips, that money must be either taxed or borrowed out of the private economy. And as I have explained elsewhere, all money in an economy is applied toward economic activity. Therefore, removing dollars destroys economic activity that would otherwise take place. So, the zero-sum dilemma.

More, even if we ignore that question and assume Tim’s rationale is correct, it does not stand under scrutiny. Imagine the argument is correct that government spending increases national income now (again, forget asking where the money comes from). At the point government either borrows or taxes money out of the economy to pay for that spending, national income decreases by an equal amount: If government spending employs resources to build a bridge and thus raises total income, government financing removes resources that would otherwise contribute to economic growth and thus lowers total income. The net effect on total income is again zero.

Stimulus advocates may build monuments to complexity attempting to justify government spending, but the logic crumbles when one asks the simple question: “Where does the money come from?”

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