So how about the weather...
columnist: Anthony Fallucco

Topic: Economics
A common misconception about government spending.

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How government spending really effects the economy.

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by Anthony Fallucco
(libertarian)
Monday, November 17, 2008

Reading through today's headlines, I and many American's grow increasingly concerned about our nation's economy. We keep hearing about the government proposing bills and other measures to increase government spending in order to help our economy. This inherently raises the question; does increased government spending really help our economy?.

When our economy is in a "rut" the federal government feels it has to be a knight in shining armor and save the economy by injecting what advocates call "stimulus" into the economy. Advocates of this practice claim the government can place money into our economy, increasing demand and therefore increasing production. This, however, is not the case. Government spending fails to stimulate economic growth because every dollar Congress "injects" into the economy must first be taxed or borrowed out of the economy. Thus, government spending "stimulus" merely redistributes existing income, doing nothing to increase productivity or employment, and therefore nothing to create additional income. Even worse, many federal expenditures weaken the private sector by directing resources toward less productive uses and thus impede income growth. Congress does not have a vault of money waiting to be spent and, as stated above, takes money out of the economy and then is redistributed. No new spending power is created.

People may rebuttal to this argument by saying stimulus takes money from "savers" and gives it to "spenders" thus leading to additional spending. This assumes the "savers" are people who store all of their money outside of the economy in places such as their mattresses. In actuality, nearly all Americans invest by purchasing financial assets such as stocks or bonds (which finances business), or they purchase non-financial assets such as real-estate or collectables, or they deposit it into banks (who quickly invest or loan the money). Whether people choose to spend or save their money, the money is always used.

Any government cannot create spending power out of thin air. The money has to come from either taxes or borrowing the money. If congress taxes the masses, existing income is merely redistributed. Congress can choose to borrow money from domestic investors but in doing so those investors have less to invest in the private economy. If Congress borrows the money from foreigners, the balance of payments will adjust by equally reducing net exports, leaving GDP unchanged. This merely reiterates the fact that the government must get their money from somewhere else.

This does not mean that government spending has no effect on the economy. Government spending often alters the composition of total demand, such as increasing consumption at the expense of investment.

More importantly, government spending can alter future economic growth. Economic growth results from producing more goods and services (not from redistributing existing income), and that requires productivity growth and growth in the labor supply. A government's impact on economic growth is, therefore, determined by its policies' effect on labor productivity and labor supply. Productivity growth requires increasing the amount of capital, either material or human, relative to the amount of labor employed. Productivity growth is facilitated by smoothly functioning markets indicating accurate price signals to which buyers and sellers, firms and workers can respond in flexible markets. Only in the rare instances where the private sector fails to provide these needs in sufficient amounts is government spending necessary. For instance, government spending on education, job training, physical infrastructure, and research and development can increase long-term productivity rates, but only if government spending does not crowd out similar private spending and only if government spends the money more effectively than businesses, nonprofit organizations, and private citizens. More specifically, government must secure a higher long-term return on its investment than taxpayers' (or investors lending the government) requirements with the same funds. Historically, governments have rarely outperformed the private sector in generating productivity growth.

Even when government spending improves economic growth rates on balance it is most certainly necessary to see the differences between immediate and future effects. Immediate stimulus from government spending does not exist because that money had to be removes from another part of the economy. However, and investment in productivity may aid future economic growth, once it has been fully completed and is being used by the American workforce. For example, spending on energy itself does not improve economic growth, yet the eventual existence of a completed, well-functioning energy system can. Those economic impacts can take years, or even decades, to occur.

Throughout history most government spending has reduced productivity and economic growth due to several factors. These factors include: taxes, displacement, incentives, and inefficiencies. Most government spending is financed through taxes. When there are higher taxes there is less incentive to work, save, and invest resulting in a less motivated workforce as well as less business investment in new capital and technology. Few government expenditures raise productivity enough to offset the productivity lost due to taxes.

Every dollar spent by politicians means one dollar less to be allocated based on market forces within the more productive private sector. For example, rather than allowing the market to give out investments, politicians seize that money and assign it for favored organizations with little regard for improvements to economic efficiency, this is displacement.

Social spending often reduces incentives for productivity by subsidizing leisure and unemployment. Combined with taxes, it is clear that taxing one person to subsidize another reduces both of their incentives to be productive, since productivity no longer determines one's income.

Government provision of housing, education, and postal operations are often much less efficient than the private sector. Government also distorts existing health care and education markets by promoting third-party payers, resulting in over-consumption and disregard for prices and outcomes. Another example of inefficiency is when politicians earmark highway money for wasteful pork projects rather than expanding highway capacity where it is most needed. These inefficiencies happen everywhere.

Still need more proof? Massive spending hikes in the 1930s, 1960s, and 1970s all failed to increase economic growth rates. Yet in the 1980s and 1990s, when the federal government shrank by one-fifth as a percentage of gross domestic product (GDP), the U.S. economy enjoyed its greatest expansion to date. Cross-national comparisons yield the same result. The U.S. government spends significantly less than the 15 pre-2004 European Union nations, and yet enjoys 40 percent larger per capita GDP, 50 percent faster economic growth rates, and a substantially lower unemployment rate (1).

Economic growth is driven by individuals, investors and entrepreneurs operating in free markets, not by Washington spending and regulations. The idea that transferring spending power from the private sector to Washington will expand the economy has been thoroughly discredited, yet congress continues to return to this strategy. The U.S. economy has grown highest when the federal government was shrinking, and it has been stunted at times of government expansion. This experience has been paralleled in Europe, where government expansion has been followed by economic decline. A strong private sector provides the nation with strong economic growth and benefits for all Americans.

 Sources:

[1] This originally appeared in Daniel J. Mitchell, "The Impact of Government Spending on Economic Growth," Heritage Foundation Backgrounder No. 1831, March 15, 2005, at http://www.heritage.org/research/budget/bg1831.cfm. The EU–15 consists of the 15 member states of the European Union before the 2004 enlargement: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom. 

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©2008 Anthony Fallucco, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Monday, November 17, 2008
Last modified: Monday, November 17, 2008

The views expressed in this article are those of Anthony Fallucco only and do not represent the views of Nolan Chart, LLC or its affiliates. Anthony Fallucco is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.

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