Earth To Keynesians, Government Spending Isn't Demand

Keynesians continue to claim the recent recession and weak recovery have as their root cause a shortage of demand. If only the government would spend more money in the short run to augment demand from the private sector, we could fully recover. At that point, miraculously, the economy begins to generate sufficient demand on its own to replace the temporary government stimulus spending and the government can go back to business as usual.

The problem with this scenario is that it misunderstands the role of demand in an economy and it also equates continuing, private sector demand with temporary government spending. Unfortunately, these two sources of demand have very different economic impacts.

First, demand cannot produce economic growth on its own. At its most fundamental level the economy is the sum of transactions between buyers and sellers, a giant marketplace where people and businesses trade goods and services for money. The key part of this concept is that every buyer requires a seller; you cannot buy a product unless somebody has manufactured it and is ready to sell. If the supply of goods to sell is unchanged, an increase of demand simply results in bidding wars among buyers and higher prices.

It is not the dollar size of an economy that counts, but its real size measured in terms of the amount of goods and services produced and sold. People want more money only to the extent that they can use it to buy more stuff (which can include savings or investments). More demand without more supply does no good, since it does not result in more goods and services being produced.

Clearly, Keynesians are not trying to simply raise prices by augmenting demand with government spending. That would produce no real economic growth, only inflation. To be effective, government stimulus spending must convince suppliers to produce more because to get the economy growing suppliers must increase supply of their goods and services; otherwise there is no growth.

An increase in supply can come from one of two sources: companies bringing idle capacity back into production or companies investing in new productive capacity (new factories, new equipment). During and after a recession, companies have lots of idle capacity that can be employed to meet a sudden increase in demand. In many cases, companies keep some employees on payroll even if there is no real work for them to do so that they will have skilled workers ready when their business comes back. This avoids the expense of finding and training new workers later and makes it worth spending some extra money keeping good workers around during slack periods.

So faced with an increase in demand due to temporary government spending, companies can respond by doing nothing and letting prices rise. That will not accomplish what the Keynesians want, but it can happen when prices are so low that businesses are losing money at current price levels. However as prices rise, profits will return and at some level of profitability firms will begin to compete for market share.

When firms competing for business choose to increase supply to meet the temporary demand, companies can meet that temporary demand by putting some of their underutilized resources back to work. Employees that had been reassigned to maintenance projects or make-work jobs can be returned to productive work. Factories or assembly lines that had been idled can be placed back in action. Unfortunately, this does not require firms to buy new equipment or to hire new workers.

When this happens, the economy may increase in size as measured by gross domestic product (GDP) since more goods and services are being produced, but unemployment is not decreased because the extra output comes from increased labor productivity.

If government boosts demand by enough that companies compete for the extra business and cannot meet that new demand by using idle workers and factories, they will move to overtime and extra shifts. Only after exhausting all these options will businesses finally start hiring new workers and investing in new factories. Even then, the companies will likely start by hiring temporary workers since they probably do not believe the demand will last.
As long as companies know that the demand created by government stimulus spending is temporary, they will be loath to base long-term investment and hiring plans on a source of demand that is supposed to go away soon. Keynesians overlook the fact that they are counting on firms to make long-term decisions based on a short-term policy.

Apparently, Keynesians believe they are smarter than the average person. They think that a government stimulus program can trick everybody (or most people) into thinking the economy is better and to resume pre-recession spending patterns. Yet experience teaches us that people are smarter than the government and we are not likely to be fooled by a government program that specifically announces to us what its purpose is.

A look at the data for the U.S. over the last few years suggests that the above scenario fits our experience. GDP has recovered much more rapidly than employment or business investment. Labor productivity has been rising since the middle of the recession, real GDP is larger than before the recession, but total employment is still two million jobs below its pre-recession peak. As further evidence, temporary employment has increased by about one million since the end of the recession.

Perhaps businesses will soon believe that conditions are favorable, with positive enough long-term prospects to hire more permanent employees. If so, we may return to more normal unemployment levels and see companies hiring more permanent and fewer temporary workers. But if that happens, it won't be because of any government stimulus spending. Only expectations of a continuing source of demand for a firm's products will induce it to expand output and employment.

Temporary government programs will not trick firms into long-term decisions. Policy makers should stop trying temporary solutions and simply focus on policies conducive to the long-run health of businesses and the economy. Tax reform that simplifies the tax code and lowers marginal tax rates would fit the bill.

Short-run policy only generates short-run responses. Policy for the long-run will yield long-lasting responses. That is what we need if we want a solid economy for future generations.