Why Governmental Stimulus Fails

Conventional demand-side Keynesian economic theory claims that when the economy is depressed, government spending will get multiplied into several times more increase in output. It is economic magic, like creating matter out of nothing.

There is one economic asset that can be created out of nothing, and that is fiat money. So the demand side policy is to create $100 billion of new money, spend it, and then, abracadabra! there magically appears $1 trillion of extra output and income. The new money has become multiplied by ten times thanks to the spending multiplier! Many economists, including Nobel-prize winners, believe in this magic. Here is how it works.

We start with the consumption function, which is private consumption as a function of income. Income is either spent for consumption or else saved, and the increase in consumption is less than the increase in savings as income grows, so savings gets ever bigger with greater income. Mathematically, C = b(Y - T), where C is private consumption, Y is income, T is taxes, and b (between zero and one) is the fraction of after-tax income used for consumption.

In an economy closed to foreign trade, output equals income, and total output Y equals the sum of consumption C, economic investment I, and government spending G, economic investment being an increase in the stock of capital goods. In the equation Y = C + I + G, substitute the consumption function for C. We derive an equation for income determination:

Y = b(Y - T) + I + G

Y = bY - bT + I + G

Y-bY = I + G -bT

Y(1-b) = I + G - bT

Y = (I + G - bT) / (1-b)

The spending multiplier is 1/(1-b). More consumption and less spending, thus greater b, makes (1-b) smaller and increases the multiplier. So if people save less and spend more, I and G will get multiplied into a much greater Y. For example, suppose b is .8, with folks saving a fifth of their income. Suppose I is $1 trillion, G is $1 trillion, and T is $1 trillion. Then

Y = (1 + 1 - .8) / .2 = 1.2 / .2 = $6 trillion of output and income.

Now increase b to .9, reducing savings to one tenth of income. We get:

Y = (1 + 1 - .9) / .1 = 1.1 / .1 = $11 trillion of output and income.

Wow! We got an increase in output of $5 trillion by reducing savings from 20 percent to 10 percent. Cut savings in half and we almost double the output! Isn’t economic magic wonderful!

But with the recession, people are saving more, not less. They are paying back debts and not spending as much. Those naughty consumers are not spending their money! The money is just sitting idle in the banks! Help! Ah, here comes government to the rescue!

Demand siders say that there is a lack of demand, and if private people are not spending enough, then government can step in to do the spending. What a wonderful doctrine for politicians! Government can spend lots of money, and the representatives can boast that they are stimulating the economy. The government borrows money and also creates money, so they can increase G without increasing T. The multiplier will then increase their spending several-fold.

But this has not happened. The US federal government spent $1 trillion for economic stimulus, and unemployment has hardly budged, and economic growth is only a couple percent annually, not the quantum leap up prescribed by the spending multiplier. Indeed, the multiplier has been less than one. Each dollar of extra government spending increases output by less than a dollar. When the government stops spending, this feeble stimulus also stops.

How do the demand-siders respond? They say that the stimulus was not big enough. But if the spending multiplier exists, it should have had a significant effect whatever its size. It’s just wrong. Can you find the flaw in the spending multiplier doctrine? Stop reading and think about it....

OK, did you figure it out? The flaw is that investment (I) is not an independent variable. Investment comes from savings. So more consumption implies less savings. If we put in an investment function as I = (1-b)(Y - T), then

Y = b(Y - T) + (1-b)(Y-T) + G

Y = bY - bT + Y - T - bY + bT + G

which gets reduced to G = T

With investment as a function of savings, there is no multiplier and no determination of income from a change in savings. Greater consumption and greater government spending do not stimulate. Yet the doctrine of demand-side stimulus is believed by most economists and by government officials. Stimulus spending did not work in Japan, and is not working in the USA.

What does work to stimulate the economy? The supply-side policy of reducing taxes on enterprise works in theory and did work in practice when presidents Kennedy and Reagan applied it. But economic growth following a tax cut can be misdirected into a real estate bubble, as happened during the presidency of George W. Bush.

The ultimate supply-side policy is to shift taxes off of labor and enterprise, and onto land value. That also prevents real estate bubbles. Only a shift to land-value taxation will promote a sustainable economic stimulus.

But spending is more popular than a tax shift, because the people are like small children who believe in the magic of a combination Big Brother and Santa Claus. Economists get government positions and columns in the New York Times by saying what the public and politicians wish to hear, that economic magic will bring us something for nothing.