Does spending create prosperity?

by Russ Roberts on September 13, 2010

in Stimulus, Uncategorized

Does spending create prosperity? It’s a weird idea when you think about it. Spending is consumption. Consumption uses stuff up. How could it create prosperity? If anything, the causation is reversed–it is prosperity that creates spending.

The Keynesian logic, though, is pretty appealing. In times when there is high unemployment, spending should create demand. Any kind of spending. So if consumers don’t want to spend, then government can stimulate the economy. And demand should create jobs, shouldn’t it, no matter where the demand comes from, right? And then the whole thing juices the system through what is usually called “circular flow” or what is also known as the Keynesian multiplier. The newly hired workers now have more money to spend. Their spending creates more demand which in turn creates more employment. And soon, the economy is humming again.

The standard argument against this story is that the money the government spends has to come from somewhere. (I’ve put forward a version of this argument myself, here.) But the real way to think about is that the resources have to come from somewhere. And when resources are highly underused (unemployment around 10%, say), this argument is not as compelling as it might be in prosperous times.

But even within the Keynesian framework and even in times of high unemployment, the aggregate demand argument is still problematic–businesses in the real world when facing an increase in demand for their products might simply decide to produce more by working current workers harder or by raising their prices instead of increasing production. Both are sensible and viable when unemployment is 10% and you and your workers are worried about the future. Employers are hesitant about hiring new workers in those conditions. Workers are eager to work a little harder rather than looking for a less demanding alternative.

But I think the better argument against the Keynesian position is more holistic. When the economy is broken, why would you think an increase in spending would get it going? Why would it have any impact other than an immediate short-term impact limited to the people who receive the money? Why would it get the whole economy going again?

Think of having a lot of wet wood and trying to get it going by lighting newspaper as kindling. There’s a fire for a while, while the newspaper is burning. But once the newspaper is consumed, the wood hasn’t caught. Even burning a lot more newspaper (bigger stimulus package) isn’t going to get the wood dry enough to catch fire.

And so we are left with an empirical question. Is the Keynesian narrative with all its modern mathematical underpinning anything more than just a story? Is it true that government spending of a dollar creates more than a dollar of economic activity? Or is it a flash that dies down and if anything, creates more pessimism about the future.

Economists from either side of the ideological aisle come up with very different answers to that question. What they do to answer that question is use various econometric techniques to tease out the independent effect of government spending holding everything else constant. The resulting estimates are all over the map.

So it is natural to look to natural experiments. The Keynesians have one. World War II. As I have argued before, there is no reason to think that government military spending did anything more than stimulate the military sector. It did not create  a boom in private consumption. Keynesians point to rising GDP and low unemployment. But if the government drafted every man, women and child to make rope and tie giant knots that the government purchased and then buried using more conscripted labor, unemployment would be zero, GDP would be large if the government set high prices for knots, and we’d all starve to death. That’s not prosperity. It’s the opposite of prosperity.

As Robert Higgs has pointed out, forcing people to serve in the military and growth as measured by GDP (that includes all those tanks and bombs and military salaries) tells you nothing about prosperity. You have to look at what people were able to consume. And what was left over after the tank and gun and bomb production wasn’t very much. Times were lousy for the economy unless you were in the military sector.

But there’s another natural experiment that has been tried with trillions of dollars.

Foreign aid.

The Western world has sent trillions of dollars to poor countries. Unlike domestic stimulus, this kind is insulated from the criticism that the resources have to come from somewhere. In the case of foreign aid, the resources come from outside the system. So this should be the ideal test of Keynesian stimulus. Most of the recipients of foreign aid have high unemployment rates. So there’s plenty of extra resources lying around waiting to be put into action.

Think of all the dams and bridges and roads and other forms of infrastructure that have been funded by international aid money.

But has foreign aid spending created prosperity in those countries? Usually not. Or maybe never. The money gets spent and then it’s over. The multiplier never materializes. And that’s because these economies are broken. They have lousy government. They have corrupt practices. They have stagnant labor markets. So the influx of money doesn’t create prosperity. It simply creates rent-seeking for the politically favored.

People will argue forever whether the Obama stimulus package was a waste of money, saved the economy from an even bigger downturn, or delayed the natural rebound of the economy. There is no evidence that it saved the economy from a bigger downturn. It could be true, but there is no evidence. The evidence that we do have on massive injections of money into broken economies is that they have little effect on the economy as a whole. They benefit the people who receive the money but do not repair what is broken.

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