Tags

On Thursday, January 8, 2009, US President-elect Barack Obama said,

I don't believe it's too late to change course, but it will be if we don't take dramatic action as soon as possible. If nothing is done, this recession could linger for years.

Most economists and various commentators are in agreement. They hold that the US government must sharply increase its spending in order to arrest the economic crisis that could turn into a prolonged slump.

According to the Congressional Budget Office (CBO), in the absence of a stimulus plan, the unemployment rate could jump to above 9% by early 2010. Some other experts are of the view that without the stimulus plan the unemployment rate could easily surpass the 10% mark.

Most experts hold that on account of the economic slump and the consequent underutilization of resources, economic output in the next two years will be strongly below the potential output. For 2009 and 2010, the production loss is estimated to be in excess of $2 trillion (the gap between the potential GDP and the actual GDP).

Therefore they believe that the effective way to close the gap between the potential output and the actual output is through the fiscal stimulus package — a large increase in government outlays.

Given the possibility that the gap could exceed the $2 trillion mark it seems that the Obama's fiscal stimulus plan of around $800 billion is not going to "do the trick."

Even if one were to allow for the so-called "multiplier effect," Obama's plan will not close the output gap and thus "fix" the problem, so it is held. In Obama's plan, only about $480 billion consists of public spending, which has a multiplier of around 1.5. (That is, a dollar of government expenditure supposedly raises GDP by around $1.5.) The rest of the package consists of tax cuts, which most experts don't believe would boost spending and thus activate the multiplier.

This way of thinking follows the ideas of John Maynard Keynes. In a nutshell, Keynes held that one cannot have complete trust in a market economy, which is inherently unstable. If left free, the market economy could lead to self-destruction. Hence there is the need for governments and central banks to manage the economy.

Successful management, in the Keynesian framework, is done by influencing the overall spending in an economy. It is spending that generates income. Spending by one individual becomes income for another individual.

"The government doesn't create any real wealth, so how can an increase in government outlays revive the economy?"

What drives the economy then is spending. If during a recession consumers fail to spend, then it is the role of the government to step in and boost overall spending in order to grow the economy.

In the Keynesian framework, an output that an economy could generate without causing inflation, given a certain pool of resources — i.e., labor, tools, and machinery, and a given technology — is labeled potential output. Hence the greater the pool of resources, all other things being equal, the more output can be generated.

If, for whatever reasons, the demand for the produced goods is not strong enough, this leads to an economic slump. (Inadequate demand for goods leads to only a partial use of existent labor and capital goods.)

In this framework then, it makes a lot of sense to boost government spending in order to strengthen demand and eliminate the economic slump.

What is missing in this story is the matter of funding. For instance, a baker produces ten loaves of bread and exchanges them for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by producing ten loaves of bread.

Note that the bread maintains the shoemaker's life and well-being. Likewise, the shoemaker has funded the purchase of bread by means of shoes that maintain the baker's life and well-being.

Now, the baker has decided to build another oven in order to increase the production of bread. In order to implement his plan, the baker hires the services of the oven maker.

He pays the oven maker with some of the bread he is producing. Again, what we have here is a setup where the building of the oven is funded by the production of a final consumer good — bread. If, for whatever reasons, the flow of bread production were disrupted, the baker would not be able to pay the oven maker. As a result, the making of the oven would have to be aborted.

From this simple example we can infer that what matters for economic growth is not just the existing stock of tools and machinery and the pool of labor but the adequate flow of final goods and services that maintains individuals' lives and well-being.

Now, even if we were to accept the Keynesian framework that the potential output is above the actual output, it doesn't follow that the increase in government outlays will lead to an increase in the economy's actual output.

It is not possible to lift overall production without the necessary support from final goods and services or from the flow of real funding or the flow of real savings. (For instance, out of the production of ten loaves of bread, if the baker consumes two loaves, his real saving or real funding is eight loaves.)

We have seen that by means of a final consumer good — the bread — the baker was able to fund the expansion of his production structure.

Similarly, other producers must have final, saved, real consumer goods — real savings — to fund the purchase of goods and services they require. Note that the introduction of money doesn't alter the essence of what funding is. (Money is just a medium of exchange. It is only used to facilitate the flow of goods; it cannot replace the final consumer goods.)

The government as such doesn't create any real wealth, so how can an increase in government outlays revive the economy?

Various individuals who will be employed by the government will expect compensation for their work. The only way it can pay these individuals is by taxing others who are still generating real wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic recovery. (We ignore here borrowings from foreigners.)

The only way fiscal stimulus could "work" is if the flow of real savings (i.e., real funding) is large enough to support (i.e., fund) government activities while still permitting a positive rate of growth in the activities of the private sector. (Note that the overall increase in real economic activity is, in this case, erroneously attributed to the government's loose fiscal policy.)

If, however, the flow of real savings is not large enough, then, regardless of any increase in government outlays, overall real economic activity cannot be revived.

In this case the more government spends (i.e., the more it takes from wealth generators), the more it weakens prospects for a recovery.

Thus when government, by means of taxes, diverts bread to its own activities, the baker will have less bread at his disposal. Consequently, the baker will not be able to secure the services of the oven maker. As a result, it will not be possible to boost the production of bread, all other things being equal.

As the pace of government spending increases, a situation could emerge where the baker will not have enough bread even to maintain the existing oven. (The baker will not have enough bread to pay for the services of an oven-maintenance technician.) Consequently, his production of bread will actually decline.

Similarly, other wealth generators, as a result of the increase in government outlays, will have less real funding at their disposal. This, in turn, will hamper the production of their goods and services, thereby retarding, not promoting, overall real economic growth.

As one can see, not only does the increase in government outlays not raise overall output by a positive multiple; but, on the contrary, this leads to the weakening in the process of wealth generation in general. According to Ludwig von Mises,