Does Government Spending Create More Economic Growth? (Spoiler Alert: No, Silly!)

Authored by Frank Shostak via The Mises Institute,

After the 2007-2009 global financial crisis, fears of ballooning public debt and worries about the drag on economic growth pushed authorities in some countries to lower government spending, a tactic that economists now think may have slowed recovery. Note that in the United States the total debt to GDP ratio stood at 349 in Q1 this year.

In a paper presented at the Kansas City Federal Reserve’s annual economic symposium on August 26 2017, Alan Auerbach and Yuriy Gorodnichenko from the University of California suggested that “expansionary fiscal policies adopted when the economy is weak may not only stimulate output but also reduce debt-to-GDP ratios”. (Fiscal Stimulus and Fiscal Sustainability, August 1,2017, UC – Berkley and NBER).

Some commentators are of the view that these findings may be welcome news to central bankers who face limited options of their own to combat a future downturn, given existing low interest rates and low inflation rates in their economies. "With tight constraints on central banks, one may expect — or maybe hope for — a more active response of fiscal policy when the next recession arrives," the University of California researchers wrote.

These findings are in agreement with Nobel Laureate in economics Paul Krugman, and other commentators that are of the view that an increase in government outlays whilst the economy is relatively subdued is good news for economic growth.

Can increase in government outlays strengthen economic growth?

Observe that government is not a wealth generating entity as such - the more it spends, the more resources it has to take from wealth generators. This in turn undermines the wealth generating process of the economy.

The proponents for strong government outlays when an economy displays weakness hold that the stronger outlays by the government will strengthen the spending flow and this in turn will strengthen the economy.

In this way of thinking, spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual"s earnings.

So if for some reason people have become less confident about the future and have decided to reduce their spending this is going to weaken the flow of spending. Once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

Following this logic, in order to prevent an emerging slowdown in the economy’s growth rate from getting out of hand, the government should step in and lift its outlays thereby filling the shortfall in the private sector spending.

Once the flow of spending is re-established, things are back to normal, so it held, and sound economic growth is re-established.

The view that an increase in government outlays can contribute to economic growth gives the impression that the government has at its disposal a stock of real savings that can be employed in emergency situations.

Once a recessionary threat alleviated, the government may reduce its support by cutting the supply of real savings to the economy. All this implies that the government somehow can generate real wealth and employ it when it sees necessary. Obviously, this is not the case.

Given that the government is not a wealth generator, whenever it raises the pace of its outlays it has to lift the pace of the wealth diversion from the wealth-generating private sector.

Hence the more the government plans to spend, the more wealth it is going to take from wealth generators. By diverting real wealth towards various non-productive activities, the increase in government outlays in fact undermines the process of wealth generation and weakens the economy’s growth over time.

The whole idea that the government can grow an economy originates from the Keynesian multiplier. On this way of thinking an increase in government outlays gives rise to the economy’s output by a multiple of a government increase.

However, is it possible that an increase in government will give rise to more output as popular wisdom has it? On the contrary, it will impoverish producers.

Producers are forced to part with their product in an exchange for goods and services that are likely to be on a lower priority list of producers and this in turn weakens the flow of production of final consumer goods.

Not only does the increase in government outlays not raise overall output by a positive multiple, but on the contrary this leads to the weakening in the process of wealth generation in general. According to Mises,

…there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens" spending and investment to the full extent of its quantity.

Contrary to our University of California researchers and commentators such as Krugman, at no stage of the economic cycle can an increase in government outlays be supportive to economic growth. On the contrary, what is required is to cut government outlays as much as possible, thus leaving more wealth in the hands of genuine wealth generators.

A cut in government outlays is great news for wealth generators and to the economy.

It is of course bad news for various artificial forms of life that emerged on the back of increases in government outlays and cannot survive without the ongoing support from these outlays.

The Broken State Fallacy - "No, Hurricanes Are Not Good For The Economy"

Authored by Caroline Baum via MarketWatch.com,

Yes, GDP may get a temporary boost from rebuilding, but there’s nothing positive about destruction

Once the immediate danger of a natural disaster subsides, and the loss of life, property damage, cost of rebuilding, and degree of insurance coverage can be assessed, attention generally turns to the economic effect. How will Hurricane Harvey affect the nation’s gross domestic product?

You will no doubt hear assertions that the rebuilding effort will provide a boost to contractors, manufacturers and GDP in general. But before these claims turn into predictable nonsense about all the good that comes from natural disasters, I thought it might be useful to provide some context for these sorts of events.

The destruction wrought by a hurricane and flooding qualifies as a negative supply shock. Normal production and distribution channels are destroyed or disrupted. Producers have to find less-efficient (i.e. more expensive) ways to transport their goods. The net effect is lost output and income, and higher prices.

Over the years, I’ve observed a tendency among economists and traders to view such events through a demand-side prism. They see lost income translating into reduced spending on goods and services, which might even warrant some largesse from the central bank.

Of course, that is precisely the wrong medicine. Supply shocks reduce output and raise prices. The Federal Reserve’s interest-rate medicine affects demand. Lower interest rates will increase the demand for gasoline, among other goods and services, but they have no effect on supply. An easing of monetary policy under such circumstances would increase demand for already curtailed supply, raising prices even more.

But wait. What about all the new construction and investment necessitated by the devastation? Homeowners will have to rebuild. Businesses will have to replace destroyed or damaged plants and equipment. Pretty soon, we should start to hear about a boost to GDP growth.

In the short run, yes. But focus on the prefix, “re,” as in re-building and re-placing. After a natural disaster, housing starts are bound to increase, but there will be no net addition to the supply of homes. Capital spending will increase as well, but it will not expand the nation’s capital stock.

Economics is about the allocation of scarce resources. A natural disaster commandeers those scarce resources in an effort to return to the status quo ante. Any boost to quarterly GDP from an increase in residential and non-residential fixed investment is an arithmetic expression of current activity, not a reflection of the wealth of a nation.

The one redeeming virtue of a natural disaster is that provides an opportunity to revisit a classic essay by the 19th century French political economist, : “That Which Is Seen and That Which Is Unseen.”

In Chapter I, “The Broken Window,” Bastiat relates the story of a shopkeeper, whose son accidentally breaks a store window. The shopkeeper has to pay six francs to the glazier to replace it. The glazier now has six francs to spend on something else. And so on. Behold all the spending that emanates from a broken window!

What is unseen is what the shopkeeper would have done with the six francs if he didn’t have to replace the window. “In short, he would have employed his six francs in some way, which this accident has prevented,” Bastiat writes.

The parable, or fallacy, of the broken window has applications elsewhere, even if no window has been broken.

Take the belief that government spending stimulates the economy, based on the notion that $1 of government spending provides the resources for someone else’s spending: something known as the multiplier effect.

If the government borrows from A to give to B, it constitutes a transfer of resources, not stimulus. (Fiscal policy gets its bang for the buck from monetary policy, or an expansion in the money supply.) A dollar spent by the government can’t be spent by the private sector. During a severe downturn or depression, when the private sector isn’t spending, government spending as short-term stimulus may be justified. But, as per Bastiat, we can’t ignore that which is unseen, or what would have happened in the absence of government co-opting savings to spend.

Estimates of the effect of fiscal stimulus are all over the map, according to a review of the financial literature by Veronique de Rugy and Matthew Mitchell, senior research fellows at George Mason University’s Mercatus Center. The estimates of the government spending multiplier range from +3.7 to -2.88. In other words, a $1 increase in government spending produces $2.70 of private-sector growth, or displaces $3.88 of private growth, or anything in between, depending on economic conditions at the time and how the money is spent.

Discussions about the merits of fiscal stimulus are generally clouded by political bias, with liberals finding huge benefits and conservatives pointing to steep costs. The cost-benefit analysis of hurricanes, on the other hand, should pose no such hurdle.

I found enlightenment back in 1992, as Hurricane Andrew was sweeping the coast of Florida. I turned on the TV to hear a business news anchor proclaim that this Category 5 hurricane would be “great news for GDP” going forward. My reaction and response to his comment proved to be one of my more memorable laugh lines when I spoke to audiences on the subject of economic nonsense.

If natural disasters are such a good deal for the economy, I said, why wait for Acts of God to come along? Why not nuke our own cities so that we can rebuild and reap the benefits?