Whenever the signs of an economic weakness emerge, most economic and political commentators declare that the government should increase spending in order to prevent the economy falling into a recession. Economic activity, in this view, consists of a circular flow of money, with one individual’s spending becoming part of the income of another individual. Spending equals income, hence more spending will mean higher incomes.
If some individuals decide to reduce their spending, their actions weaken the circular flow of money. If an individual spends less, the incomes of others are lessened and they, in turn, reduce their purchases of goods from other individuals. As a result, overall spending on goods and services declines and, thus, overall income falls, too.
Following this logic, in order to prevent a downward spiral, mainstream economists claim the government should step in and increase its outlays, thereby filling the shortfall in private sector spending. Thus, government spending is a vital agent of economic growth.
The Magic of the Keynesian Multiplier
John Maynard Keynes popularized the view that an increase in government outlays causes the economy’s income to increase by a multiple of the initial government increase. The following example illustrates the essence of this way of thinking.
Assume that in order to strengthen the pace of economic activity, the government decides to increase its expenditure by $100 million. Assume also that out of each additional dollar received, individuals spend ninety cents and save ten cents.
Once the government increases its outlays, the amount of money in individuals’ possession increases by $100 million. Given that individuals spend ninety cents of an additional dollar received, this means that they are going to spend 90 percent of the $100 million, so they will increase expenditure on goods and services by $90 million.
The recipients of this $90 million in turn spend 90 percent of the $90 million, which is $81 million. Then, the recipients of the $81 million spend 90 percent of this sum, which is $72.9 million, and so on. Note that the key in this way of thinking is the belief that the expenditure of one person becomes the income of another person.
At each stage in the spending chain, individuals spend 90 percent of the additional income they receive. This process eventually ends, with total income higher by $1 billion than it was before government increased its expenditure by $100 million, with the multiplier being 10 ($100 million x 10 = $1 billion). Observe that the more of the additional income is spent, the greater the multiplier is going to be and, therefore, larger the impact of the initial spending on the overall income.
For instance, if individuals change their habits and spend 95 percent of each dollar, the multiplier is going to become 20. Conversely, if they decide to spend only 80 percent and save 20 percent, then the multiplier is going to decline to 5. This means that the less individuals save, the larger the impact of a demand increase on overall income is going to be. According to John Maynard Keynes,
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.1
Fiscal Stimulus and Economic Growth
If government spending does not generate new wealth, how can an increase in government outlays revive the economy? First, people employed by the government are compensated for their work; then, these workers spend the proceeds and supposedly expand the economy.
However, note that the government pays these individuals by taxing entrepreneurs and private business workers who are actually generating wealth. By doing this, the government weakens the wealth-generating process and undermine prospects for economic growth. The following example clarifies this point further.
In an economy that is comprised of a baker, a shoemaker, and a tomato grower, another individual enters the scene, an enforcer exercising his demand for goods by means of force. The baker, the shoemaker, and the farmer are forced to part with their products in an exchange for nothing. As a result, all other things being equal, their ability and willingness to produce goods weakens. This in turn undermines the production flow of final consumer goods. According to Ludwig von 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.2
Fiscal stimulus can “work” as long as the flow of savings is expanding, since the expanding savings fund government activities while still permitting an increase in the activities of wealth generators. However, if the flow of savings declines, then overall economic activity cannot be revived. In this case, the more the government spends, the more it takes from wealth generators and the more it weakens prospects for economic growth.
Thus, when the government by means of taxes diverts bread to its own activities, the baker is going to have less bread at his disposal. Consequently, the baker is not going to be able to secure the services of the oven maker to build a new oven. As a result, it is not going to be possible to increase the production of bread, all other things being equal.
As the pace of government spending increases, a situation could emerge in which the baker is left with too little bread to hire a technician to maintain the existing oven. Consequently, the baker’s production of bread is going to decline, all other things being equal.
Similarly, because of the increase in government outlays, other wealth generators are going to end up having less funding at their disposal. This in turn is going to hamper their production of and retard rather than promote overall economic growth.
We can thus conclude that an increase in government outlays is not going to raise the economy’s income by a multiple of the initial increase. On the contrary, the increase in government outlays will weaken the overall income, all other things being equal.
What Causes Recessions?
Central bank policy makers (such as those at the Federal Reserve) regard the central bank as the responsible entity authorized to bring the economy onto the path of stable growth and prices. These policy makers decide what the “right” growth rate should be.
Consequently, any deviation from the predetermined stable growth path determines the central bank’s response, whether it employs a tighter or a looser stance. This response in turn affects the fluctuations in the money supply’s growth rate.
Observe that loose central bank monetary policy, which results in an expansion of money supply out of “thin air,” sets in motion an exchange of nothing for something, which amounts to a diversion of savings from wealth-generating activities to non-wealth-generating activities.
Loose monetary policy produces the same outcome as the counterfeiter does. Its diversion of savings weakens wealth generators and thus their ability to grow the overall pool of wealth.
The various activities that emerge on the back of a loose monetary policy are labeled bubble activities. An increase in bubble activities, which generates the impression of an expanding economic growth, is labeled an economic boom.
Bubble activities cannot stand on their “own feet.” These activities are supported by the expansion of the money supply, which diverts wealth generators’ savings to them.
Also, note that once the central bank increases the pace of monetary expansion, the pace of the diversion of savings toward bubble activities also increases. Once, however, the central bank tightens its monetary stance, this slows the diversion of savings.
Because bubble activities cannot stand on their own feet, these activities require ongoing increases in the growth rate of money supply in order to survive. (Again, the increase in money supply diverts to them consumer goods. These consumer goods are the savings of wealth generators.)
When the central bank takes tighter monetary stance, bubble activities that sprang up on the back of the previous loose monetary policy get less support. They are in trouble—an economic bust emerges. Recessions, then, are not about the weakening of economic activity but rather about the liquidation of the various bubble activities that sprang up on the back of increases in the money supply out of “thin air.”
Aggressive monetary policy, which creates bubbles, weakens wealth generators, thereby diminishing economic recovery. Once the economy falls into a recession, the central bank should restrain itself and do nothing to counter the economic downturns. Recessions are in fact good news for wealth generators, since recessions demolish bubble activities that weaken wealth producers.
During an economic crisis, what is required is for the government and the central bank to do as little as possible. With less tampering, more wealth remains with wealth generators, allowing them to expand the pool of savings.
With a larger pool of savings, it is easier to absorb various unemployed resources. Aggressive monetary and fiscal policies that undermine the process of wealth generation make things much worse.
As long as the pool of savings is still expanding, the government and the central bank can pass off the illusion that they can grow the economy. However, once savings begin to stagnate or decline, the illusion is shattered.
1. John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1964), p. 129.
2. Ludwig von Mises, Human Action: A Treatise on Economics, 3rd rev. ed. (Chicago: Contemporary Books, 1966), p. 744.