The Keynesian Stimulus Spending Fallacy

by Polly Cleveland | December 28, 2012

It’s a truism of pop Keynesian economics that consumer spending drives the economy; if spending slows in a recession, government must make up the difference. In reality, consumer spending merely signals what consumers want; producers may be unable or unwilling to deliver. Government spending may compensate—or make matters worse—depending on the type of spending and whether it’s financed by progressive taxes or by borrowing.

The logic of spending runs loosely as follows: I spend $1 at the grocery store. The grocer spends $.80 of that at the gas station. The gas station owner spends $.80 of that at the barber, and so on. By the logic of an infinite series, my one dollar in spending has generated an additional $4 dollars in spending; or the “multiplier” is 4. And with that additional spending comes another $4 in production. However if I leave that dollar in the bank, and the bank doesn’t lend it to someone else to spend, then government must spend it to keep the economic machine running. Sounds plausible, doesn’t it?

But there’s a weak link: the assumption that spending automatically leads to production and jobs.

Consider a small businesswoman. She manufactures wooden jig-saw puzzles. Every month she decides how many puzzles to make, and hence how many hours to schedule for her employees. What does she consider? First, she estimates her next month’s sales from sales last month and previous months. That is, she plans how much to produce based on consumer spending. But then she considers how much cash she has available to pay for plywood and workers’ wages. Small businesses often operate on lines of credit, borrowing each month for payroll and materials, paying back loans with cash following sales. If—as happens in a recession—banks reduce credit and customers delay paying, our puzzle-maker cuts back planned production and lays off workers.

Now consider a large profitable conglomerate, an aggregation of dozens of businesses and thousands of products. Such an enterprise faces no shortage of cash in a recession (see my last post on cash-hoarding multinationals). But management turns cautious. It shuts down less profitable business lines and lays off workers, even when there’s still substantial demand. Likewise big banks turn cautious, denying credit even to steady customers like our puzzle-maker.

In short, when a recession makes cash tight for small business, and confidence low for large business, consumer spending does not translate into production and jobs.

Can government spending nonetheless create production and jobs to replace those lost in a recession? That depends first on the type of spending. Military spending is the worst. First it creates very few jobs per dollar spent; second, it creates limited (or negative) benefits. Contrast that with urban services: street and sewer repair, garbage collection, schools, police, fire, welfare and health provision—all of which create many jobs per dollar spent.  Add in Federal safety-net spending–notably Social Security, Medicare, Medicaid, and unemployment insurance. Without these services operating invisibly in the background, neither the puzzle-maker, nor the conglomerate, nor their customers would survive. Here’s where government should spend more during a recession, not cut back. (This does not justify highways and bridges to nowhere, which don’t rate much above military spending.)

The effectiveness of government spending also depends on how it’s financed. Local government services raise property values; when property owners pay property taxes, they pay for benefits received. However excessive borrowing undermines benefits of government spending. I’ve dealt with this at length in Deficit Hawk, Progressive Style, Parts I and II.

It’s a harmful myth that spending drives the economy. It makes us think we can rev up the economy by any old government spending, financed any old way. In reality, we need productive, job-creating, service-providing government, supported by progressive taxes.

There is one thing in economics that leaves me perplexed.

Economists say that economics is a science. They constantly speak of numerical measures, objectivity, hard evidence and such.

Fair enough.

And yet, at every turn they appeal to the flimsiest, more subjective notions as foundation for their theories.

Think of utility and entrepreneurship, for one.

Here you appeal to business “confidence”. What is confidence? What is it that makes big business so insecure? Why small business behave differently? After all, this is your explanation: big business hoard money because they are less confident than small business.

The simpler and **measurable** alternative explanation is that big business hoards money because demand for their goods is low, therefore, they do not find it profitable to spend that money in producing anything.

———-

The other thing is the notion that the federal government needs to either borrow or collect taxes to finance its spending. God, that’s just not true.

  • Maybe Polly should actually read what JM Keynes wrote before she writes such an inane article.

    There should be a copy of JMK’s ‘General Theory’ at her local JC library.

  • I agree that more productive spending and regulation will stimulate the economy but I seriously doubt the government’s ability to fulfill this objective given the current political climate and the principal agent problem with our elected officials and lobbying sponsored legislation. I also disagree with JMK when he said that “government spending while not the best use of economic resources is certainly better than nothing” as the concept of nothing in economics does not exist. Institutions, firms, governments, and individuals always act therefore this assumption is based on fallacy.

  • Here’s what Keynes said in his Jan. 1933 open letter to President Roosevelt. It agrees with the stated thesis of Polly Cleveland’s article:
    Section 5,
    “The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come n the market. Broadly speaking, therefore, and increase of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out o their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.” See this reference: http://newdeal.feri.org/misc/keynes2.htm

  • Well, yes and no. I do agree with the Keynes quote that in a downturn government can and should make the most immediate response, as by unemployment insurance and other “automatic stabilizers.” However beyond that, it depends on how government money is spent and how financed. Capital-intensive spending as on military or roads and bridges to nowhere drains working capital from job-creating small business. So does financing “through the expenditure of borrowed or printed money” rather than by taxes on the rich and on the profits of major corporations.

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