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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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Jeff Y.OK. The foreign aid example is brilliant. It has that feeling of obviousness that characterizes a good enthymeme.
http://profiles.yahoo.com/u/RSCKU4T5X5QGYBSM2HSTNCGKAI MichaelThink 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.
Russ, that’s a wonderful analogy! Please tell me you’re using it in the classroom…
http://occamsrazr.com Ike PigottAgreed. It is so tightly-wound in details with the Keynesian Stimulus, there aren’t enough avenues to wiggle out. (Unless you blame the people in those countries for being inferior or lazy… and that’s just too close to racism for liberals to say it.)
http://occamsrazr.com Ike PigottGreat example with the wood… just let it dry.
The analogy I have used is fishing on the lake. As long as the lake it calm and clear, fishermen are comfortable easing their lines into the water for deeper fishing.
When the water gets turbulent and cloudy, there are fewer lines in the water as we become more risk averse.
Keynesian Stimulus is predicated on the theory that the best way to combat those choppy waters is by throwing large boulders into the lake. In reality, you just start new waves of turbulence and kick up even more silt. (And when you throw enough rock into the lake, you threaten to change the water level completely, to the point where no one knows what “deep” means anymore.)
Fishermen won’t put their lines into the water… and may not even bring their boats to the lake until the damned politicians quit launching boulders.
StephanRuss Roberts as we know him: hysterical … Always loyal to the ideological mission and ready and willing to serve nonsense for the purpose of the good.
Hmmm … what is somebody saying who has a little bit more economic credentials to offer than some Russ Roberts. Like nobel laureate William Vickrey:
“The ‘deficit’ is not an economic sin but an economic necessity. Its most important function is to be the means whereby purchasing power not spent on consumption, nor recycled into income by the private creation of net capital, is recycled into purchasing power by government borrowing and spending. Purchasing power not so recycled becomes non-purchase, non-sales, non-production, and unemployment.”
And please spare me with the Higgs paper on the Great Depression. “Regime Uncertainty; Why the Great Depression Lasted so Long and Why Prosperity Resumed After the War” is so thoroughly debunked no one except hardcore Austrian ideologues mention it meanwhile.
I would suggest you educate yourself on the balance sheet approach developed by Wynne Godley and others and once you can credible refute this approach start sputtering again about spending.
http://twitter.com/Unfashenomic Nick BormannAgreed. That’s a line of argument I hadn’t heard before. I think it’s pretty compelling — if a money multiplier has all the positive effect that some Keynesians would claim, it should have been apparent from foreign aid
WheresthemathematicalformalismThe 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?
This amateurish rhetoric is really beneath you, Russ.
muirgeo“Does spending create prosperity?”
I think it quite clearly does. The government spent money to help create this internet, microprocessors, satellittes, nuclear power, vaccines and brilliant graduates from the University of California to fuel Silicon Valley and now the Biotech industry.
Good governement is the friend of good economies and until we learn that and change from the idea that minimalist governement is always better than good government we will slowly sink in the direction of those thiird world countries who ALSO have minimalist govenments.
Plan and simply minimalist government gets you concentrated wealth and power with decreased overall effeciency.
http://twitter.com/mpeg2tom mpeg2tom“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.”
Something I have been thinking about recently is the scale up of military manufacturing during WWII as being a catalyst for a de-ruralization to solve a “structural problem” in employment.
A lot of people were unemployed in agriculture as productivity ramped up due to chemical fertilizer and the internal combustion engine and other farm mechanization. That combined with the dust bowl and the Depression made rural life difficult. Farmers who owned their land often made it through OK, but rural service jobs or migrant agricultural workers or tenant farmers were the worst off.
Perhaps previously rural workers were brought into the manufacturing industry by WWII military production, and then were able to use those new work skills in post-WWII consumer product manufacturing. I’ve read that 630,000 “Okies” migrated from rural areas to West coast areas with military manufacturing jobs during the 1940s.
RussRobertsI always appreciate constructive criticism. I haven’t seen any “debunking” of Higgs. Can you provide a link? And I’d also like to see a reference to the prosperity of Americans (or Brits or Germans) during WWII.
BTW, there are plenty of people with credentials on both sides of Keynes. It’s not really about credentials, but logic and evidence.
RussRobertsJust quoting my Keynesian friends.
http://ourdinnertable.wordpress.com Seth“And when resources are highly underused (unemployment around 10%, say), this argument is not as compelling as it might be in prosperous times.”
But the resources still have to come from somewhere. Is there evidence that it comes from the underused resources?
I like the analogies. But, I have to question, is the stimulus the burning of the kindling or is the moisture in the wood or both?
AnonymousAt first glance, this seems to have five glaring mistakes: 1. You seem to conflate growth policy with full employment policy. These strike me as two very different things. 2. You seem to be operating under the assumption that there is an immutable amount of this thing called “money”. 3. You seem to think that demand consists only of consumption. 4. In your example, you seem to sever the relationship between government spending and the issuance of government bonds in Keynesian policy recommendations, and you seem to be arguing that this makes it a good test case. 5. You seem to assume that demand-side problems are the primary limitation in developing countries. Is this true? I would have assumed it wasn’t true. I’ll need to reread – perhaps I’m misunderstanding some of this.
AnonymousTruly excellent point on foreign aid.
AndyBrad DeLong, 11/30/09: “At this point, anything that boosts the government’s deficit over the next two years passes the benefit-cost test–anything at all.”
GrubmanBut a Keynesian would argue the comparison is flawed because poor countries are not in liquidity traps and on the brink of deflation, hence apples to oranges.
Bill SteppRight, like Keynesians digging ditches. DeLong is an anti-economist.
Smoke this:
Y = C + I – (G + T).
http://blsciblogs.baruch.cuny.edu/luc/ Mike P.F.I usually disagree with the bulk of what you and Prof. Boudreaux write because the issues you two write about seem to be discussed from a very black-and-white point of view.
However, I have to totally agree with your assessment of government spending for the ambiguous goal of boosting aggregate demand. It’s an ideological distortion that government spending injections will only act as anything more than short-term bandages to the economy (though not totally unnecessary). Economic prosperity depends on how secure households and firms feel about their long-term prospects for steady income streams. In turn, they will spend and save to maximize their respective utilities.
Probably the most important factor to be taken into consideration, with regard to the effectiveness of government spending injections, is the underlying structure of the economy. Given the size, complexity, and dynamism of the U.S. economy, I highly doubt any amount of government spending will do anything more than inefficiently allocate resources that could have been efficiently allocated by the private sector…for the purpose of long term growth.
Bill SteppThe State didn’t create the internet, nor did it create the other stuff. Everything the criminal entity known as the State does is done with money stolen from taxpayers, who earned it via production. The brilliance of those graduates wasn’t created by the U. of Cal. They were smart before they went there, and succeeded despite going there. They would have done as well if not better at private schools.
AnonymousPicture an ant colony split into groups harvesting four food sources. The fourth group finishes up their food source and become ‘unemployed.’ If a host of caterpillars invade the colony, they can be re-purposed to fight. But doing so is ultimately a drain on the colony, not a boon. It is really a broken window. And when the war is over, they will again need to be re-purposed to find more food. Fighting the war did nothing to help them find more food.
So now the fourth group of ants is idle again. We as human observers could plant more food for them to eat. The cost is our time and food preparation. We are giving the ant colony help it otherwise would not have. When that food is gone, they will again need to forage for food. All we did was delay their adaptation to the environment at an extra cost to the system. Eventually they will have to find the food themselves, wherever in their environment they can find it.
It is true that as long as we are ready to forgo our own opportunity costs, we can artificially keep the ant colony well fed. But at some point they will need to fend for themselves.
In our own economy, the issue is worse, since the money that the government spends is taken from our own economy. It either induces spending today that would have been spent tomorrow, or it robs the spending of someone else to spend it on its own priorities. But in any case, and like the ant colony, it does not produce ultimately productive behavior, since as soon as we stop, the colony must continue adapting to the new reality in which it finds itself, and find a new source of food.
In 2007 the construction industry tanked. Any government ‘stimulus’ only slows down the adaptation of the complex economic system from re-apportioning those workers (and the rippling effect they had on the economy) to pursuits that the market values more highly.
There is one more lesson the ant colony teaches us. The colony does not live happily in its environment because it consumes. Consumption is the result. It lives and survives because it searches and forages.
In the human economy, foraging equals investing; to employ the unemployed, organizations must invest in something new (find a new food source) and hire humans to cultivate it. Relatively few investments are now being made because of fear of failure, and because their creativity has not yet yielded enough practical ideas of where to invest (forage).
I believe my analogy also explains why foreign aid does not work.
Bill SteppAs Rothbard pointed out in Man, Economy, and State, consumption takes care of itself. People will always cut back on luxuries if they have to. But what happens if capital spending is cut to zero, as it would be under a scenario of capital consumption or capital flight? (Hello, Zimbabwe.) Pretty soon there would be no consumption above a bare bones miminmum. Investment in capital (and innovation) create prosperity, not consumption.
muirgeo“The State didn’t create the internet…” Bill Sterr
Yeah right there is no internet. And I am NOT typing on a computer made from microprocessors. I guess I am not emailing you this and you’re not reading my email so be sure not to really reply. Whatever…..
Your argument is a little like me saying private industry has never made any money because it was the government that printed all the money… like I said… whatever…
Steve A.I would be very much interested in seeing how the amount of stimulus received by the various states corresponds with the change in employment statistics for those states. I highly expect that the states that received the most stimulus money relative to population are the states with the least improvement in unemployment rates.
MichaelSmithStephan quoted William Vickrey:
“The ‘deficit’ is not an economic sin but an economic necessity. Its most important function is to be the means whereby purchasing power not spent on consumption, nor recycled into income by the private creation of net capital, is recycled into purchasing power by government borrowing and spending. Purchasing power not so recycled becomes non-purchase, non-sales, non-production, and unemployment.”
In the first place, that is merely restating the very claims that are being debated, which means that all you are offering is an argument from authority. Hardly persuasive given that there are various economic authorities on both sides of the question.
Second, Robert Higgs has a far more persuasive approach. He looks at the actual data in the national accounts. Higgs' article is here:
http://www.independent.org/blog/index.php?p=7693
His main point is that it is not primarily private consumption spending that has collapsed — it is private investment spending — and that this is typical in recessions and depressions. In other words, the actual data shows that the business cycle is driven far more by changes in investment spending than changes in consumption spending.
Regarding our current situation, consumption spending declined from its 4th quarter 2007 peak of $9,342.3 billion to a bottom of $9,117.0 billion in 2nd quarter of 2009 — a decrease of only $225.3 billion.
Private investment expenditure, however, went from its quarter 1, 2006 peak of $2,264.7 billion to a 2nd quarter 2009 bottom of $1,453.2 billion — a decrease of $811.5 billion, far larger than the $225.3 billion drop in consumption spending.
Meanwhile, private consumption spending has returned to the level it was at in 2006 — yet we remain with 10% unemployment. If boosting consumption spending were the key to economic recovery, it would have happened by now. It hasn't.
As
OK. The foreign aid example is brilliant. It has that feeling of obviousness that characterizes a good enthymeme.
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.
Russ, that’s a wonderful analogy! Please tell me you’re using it in the classroom…
Agreed. It is so tightly-wound in details with the Keynesian Stimulus, there aren’t enough avenues to wiggle out. (Unless you blame the people in those countries for being inferior or lazy… and that’s just too close to racism for liberals to say it.)
Great example with the wood… just let it dry.
The analogy I have used is fishing on the lake. As long as the lake it calm and clear, fishermen are comfortable easing their lines into the water for deeper fishing.
When the water gets turbulent and cloudy, there are fewer lines in the water as we become more risk averse.
Keynesian Stimulus is predicated on the theory that the best way to combat those choppy waters is by throwing large boulders into the lake. In reality, you just start new waves of turbulence and kick up even more silt. (And when you throw enough rock into the lake, you threaten to change the water level completely, to the point where no one knows what “deep” means anymore.)
Fishermen won’t put their lines into the water… and may not even bring their boats to the lake until the damned politicians quit launching boulders.
Russ Roberts as we know him: hysterical … Always loyal to the ideological mission and ready and willing to serve nonsense for the purpose of the good.
Hmmm … what is somebody saying who has a little bit more economic credentials to offer than some Russ Roberts. Like nobel laureate William Vickrey:
“The ‘deficit’ is not an economic sin but an economic necessity. Its most important function is to be the means whereby purchasing power not spent on consumption, nor recycled into income by the private creation of net capital, is recycled into purchasing power by government borrowing and spending. Purchasing power not so recycled becomes non-purchase, non-sales, non-production, and unemployment.”
And please spare me with the Higgs paper on the Great Depression. “Regime Uncertainty; Why the Great Depression Lasted so Long and Why Prosperity Resumed After the War” is so thoroughly debunked no one except hardcore Austrian ideologues mention it meanwhile.
I would suggest you educate yourself on the balance sheet approach developed by Wynne Godley and others and once you can credible refute this approach start sputtering again about spending.
Agreed. That’s a line of argument I hadn’t heard before. I think it’s pretty compelling — if a money multiplier has all the positive effect that some Keynesians would claim, it should have been apparent from foreign aid
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?
This amateurish rhetoric is really beneath you, Russ.
“Does spending create prosperity?”
I think it quite clearly does. The government spent money to help create this internet, microprocessors, satellittes, nuclear power, vaccines and brilliant graduates from the University of California to fuel Silicon Valley and now the Biotech industry.
Good governement is the friend of good economies and until we learn that and change from the idea that minimalist governement is always better than good government we will slowly sink in the direction of those thiird world countries who ALSO have minimalist govenments.
Plan and simply minimalist government gets you concentrated wealth and power with decreased overall effeciency.
“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.”
Something I have been thinking about recently is the scale up of military manufacturing during WWII as being a catalyst for a de-ruralization to solve a “structural problem” in employment.
A lot of people were unemployed in agriculture as productivity ramped up due to chemical fertilizer and the internal combustion engine and other farm mechanization. That combined with the dust bowl and the Depression made rural life difficult. Farmers who owned their land often made it through OK, but rural service jobs or migrant agricultural workers or tenant farmers were the worst off.
Perhaps previously rural workers were brought into the manufacturing industry by WWII military production, and then were able to use those new work skills in post-WWII consumer product manufacturing. I’ve read that 630,000 “Okies” migrated from rural areas to West coast areas with military manufacturing jobs during the 1940s.
I always appreciate constructive criticism. I haven’t seen any “debunking” of Higgs. Can you provide a link? And I’d also like to see a reference to the prosperity of Americans (or Brits or Germans) during WWII.
BTW, there are plenty of people with credentials on both sides of Keynes. It’s not really about credentials, but logic and evidence.
Just quoting my Keynesian friends.
“And when resources are highly underused (unemployment around 10%, say), this argument is not as compelling as it might be in prosperous times.”
But the resources still have to come from somewhere. Is there evidence that it comes from the underused resources?
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