The abstract to Brian Riedl’s Heritage Foundation paper Why Government Spending Does Not End Recessions: Answering the Critics reads:
Despite decades of repeated failure, President Obama and Congress continue to promote the myth that government can spend its way out of recession. Heritage Foundation economic policy expert Brian Riedl dispels the stimulus myth, lays out the evidence that government spending does not end recessions–and presents the evidence for what does end recessions. Hint: It’s not another “stimulus package.”
These are strong words. The arguments presented in the paper, in contrast, are not. Picking them apart is an easy task, but may be instructive and also serve a purpose given the influence right-wing “think tanks” seem to have on the mainstream policy debate.
Riedl makes a serious and basic error at the beginning of the section, “Why Government Spending Does Not End Recessions”.
Spending-stimulus advocates claim that Congress can “inject” new money into the economy, increasing demand and therefore production. This raises the obvious question: From where does the government acquire the money it pumps into the economy? Congress does not have a vault of money waiting to be distributed. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another.
Congress cannot create new purchasing power out of thin air. If it funds new spending with taxes, it is simply redistributing existing purchasing power (while decreasing incentives to produce income and output). If Congress instead borrows the money from domestic investors, those investors will have that much less to invest or to spend in the private economy. If they borrow the money from foreigners, the balance of payments will adjust by equally raising net imports, leaving total demand and output unchanged. Every dollar Congress spends must first come from somewhere else.
There is no financial need to tax or borrow to fund net expenditure, but there is currently a legislative requirement in many countries, including the US, to match government expenditure with taxes and borrowing. Even so, it is a bad error to suppose that this means net government expenditure (government expenditure, G > tax revenue, T) has no impact on real output. This would only be true if the economy were at full employment. Riedl is conflating and misapplying different concepts.
We can look at this in two ways: in terms of non-government net financial assets, or in terms of the quantity of money, M, and real output, Y.
To begin, consider the situation in terms of net financial assets. When the government net spends, it pays more into non-government bank accounts than it withdraws in taxes. As a result, there is a net increase in non-government bank accounts and bank reserves with the Fed. That is, there is an increase in net financial assets held by the non-government sector. The fact that the non-government sector uses the extra funds to purchase government bonds drains reserves from the system but has no effect on net financial assets. In this transaction, the non-government sector simply exchanges one financial asset (reserves) for another financial asset (bonds). So the deficit expenditure by the government increases net financial assets. The purchase of government bonds by the non-government sector has no impact on the level of net financial assets – it merely alters their form. Overall, the government net expenditure has increased non-government net financial assets.
To see this more clearly, think of the reverse scenario of a budget surplus (T > G). By Riedl’s reasoning, net taxing would have no impact on the amount of net financial assets held by the non-government sector. After all, to make the net tax payments, the non-government sector would have to run down bank balances or sell bonds back to the government in order to meet its tax obligation. But this government action will clearly reduce net financial assets. The budget surplus withdraws more funds from non-government bank accounts through taxing than it adds through spending. This reduces net financial assets. The fact the non-government sector exchanges some bonds for reserves has no impact on the level of their holdings of net financial assets. It merely exchanges one financial asset (bonds) for another financial asset (reserves). The overall effect of the budget surplus is unambiguous: net financial assets decrease.
To look at this another way, consider what happens in terms of the quantity of broader money (meaning currency plus deposits), M, and real output, Y. The government net spends. Its spending is undertaken to purchase real goods and services from the non-government sector. The non-government sector must either increase output to meet the government orders, or run down inventories, either of which is a strong impetus to production. So the effect of the government expenditure is to increase real output. The effect of the taxation is to withdraw some non-government spending power, which taken in isolation acts to reduce real output. However, since the government has net spent (G > T), the overall effect is an increase in output.
Now consider what happens in terms of the quantity of money, M. The effect of the net expenditure is that the government credits non-government bank accounts (through spending) more than it debits them (through taxing). This in itself would cause a build up of non-government bank deposits. That is, an increase in M. But the non-government sector also purchases government bonds that the government issues to adhere to the legislative requirement that it match net spending with debt dollar for dollar. This in itself reduces non-government bank deposits (reduces M) and increases non-government holdings of bonds. The overall impact on M is zero.
So taking all these things together, we have an increase in real output, Y, as a result of the government net expenditure. We have an increase in non-government net financial assets, held in the form of bonds. And we have no change in M. In other words, the government net spending has increased real output and non-government net financial assets and yet still left M unaffected. So the M available for purchases of goods and services remains undiminished, yet real output has increased.
Riedl has tumbled at the starting gate.
But let’s continue for the sake of argument. Riedl then writes:
For example, many lawmakers claim that every $1 billion in highway stimulus can create 47,576 new construction jobs. But Congress must first borrow that $1 billion from the private economy, which will then lose at least as many jobs. Highway spending simply transfers jobs and income from one part of the economy to another. As Heritage Foundation economist Ronald Utt has explained, “The only way that $1 billion of new highway spending can create 47,576 new jobs is if the $1 billion appears out of nowhere as if it were manna from heaven.” This statement has been confirmed by the Department of Transportation and the General Accounting Office (since renamed the Government Accountability Office), yet lawmakers continue to base policy on this economic fallacy.
First, the funds do appear like “manna from heaven”. The government has used its capacity to increase net financial assets. The fact that the non-government sector alters the form of these financial assets has no further implications for the overall level of net financial assets.
Second, the claim that “[h]ighway spending simply transfers jobs and income from one part of the economy to another” is untrue if there are idle resources and the economy is operating below the full-employment level. The government’s decision to put some idle resources to work in no way prevents the non-government sector from putting other idle resources to work, because the non-government purchasing power embodied in M has remained unaffected by the combined effects of the deficit expenditure and non-government bond purchases, and in fact non-government net financial assets have increased.
To see the falsity of Riedl’s claim, imagine (purely as a thought experiment) that there was no money, just real resources. Currently, a lot of these resources are idle. If the government chooses to make use of some but not all of these resources, clearly there are still resources left over that can be put to use by the non-government sector. Fiat money does not change this aspect of the problem one iota. If the government uses its fiat money to activate some but not all idle resources, it in no way prevents the private sector from using its fiat money (which has fallen like “manna from heaven” courtesy of the government) to put the remaining idle resources to work. Again, the government action has left M unaffected and increased non-government net financial assets, and so in no way inhibits non-government purchasing power or its capacity to employ idle resources.
Riedl’s argument obscures and mystifies what is actually going on in terms of real resources. The real basis of society’s productive potential is its available resources, including labor resources. If, for whatever reason, the non-government sector is not fully utilizing these resources, the government can utilize those that are left idle.
Riedl then quotes a Chicago (or “new classical” – a variant of neoclassical) economist, John Cochrane as follows:
First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of “crowding out” is just accounting, and doesn’t rest on any perceptions or behavioral assumptions.
This argument – attributed to Cochrane – is patently incorrect when the economy is operating below full employment. (For this reason, it is possible that Cochrane was referring to a full-employment situation in this passage. I haven’t checked. I will just respond to the use with which Riedl is putting Cochrane’s passage.) Once again, there is the false suggestion that government borrowing negates any real effect on output because it leaves the non-government sector with less purchasing power. In reality, the government policy has added to output while increasing non-government net financial assets and spending power. There is a world of difference in these two depictions of government net expenditure.
The remainder of the first paragraph quoted from Cochrane is inapplicable unless there is full employment. Whenever the economy is operating below full employment, it is possible to produce more roads and more factories. Cochrane may as well say that if the non-government sector builds roads, it can’t also build factories, even if the building of roads still leaves idle resources available for building factories. For this reason, it is ironic that Cochrane’s very next paragraph commences with “investment is ‘spending’ every bit as much as consumption”. Of course it is. And government expenditure is spending every bit as much as private investment and consumption.
But there is another tell-tale sign that Cochrane’s argument, as depicted by Riedl, is based on flawed logic:
Keynesian fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather than save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.
This argument is expressed in a very slippery way, but he is equating saving to investment. He is claiming that every act of saving is inevitably also an act of private investment. Saving, he implies, calls forth investment. This claim has a name: Say’s Law. It was discredited first by Marx, then by Keynes and Kalecki. Neoclassicals cling to it in the ‘long run’. It is the basis for their claim that there is an automatic adjustment to full-employment output. If there is a sharp reduction in consumption, the rise in saving is meant to result in a real interest-rate adjustment that induces an offsetting increase in private investment. The economy, for a new classical like Cochrane, need not even deviate from full employment during this switch from consumption to investment. If it does, it is because individuals made random expectational errors that caused, to take one example, workers to demand higher wages than were consistent with their continued employment. Thus they were laid off.
The argument is invalid and is partly what the capital debates were about. First, it is invalid and a fallacy of composition to suppose an inverse, monotonic relation between the real general rate of interest and aggregate private investment. Say’s Law does not hold, in the long run or otherwise. Second, it is invalid to suppose that a reduction in real wages will translate into an increase in aggregate employment. This is also a fallacy of composition, and was another casualty of the capital debates, and also a casualty of other aggregation problems uncovered later by neoclassical economists themselves.
Government spending can affect long-term economic growth, both up and down. Economic growth is based on the growth of labor productivity and labor supply, which can be affected by how governments directly and indirectly influence the use of an economy’s resources. However, increasing the economy’s productivity rate–which often requires the application of new technology and resources– can take many years or even decades to materialize. It is not short-term stimulus.
The claim here is that growth is supply determined. Actions that increase potential output will automatically induce the full utilization of this higher potential output. It is the same argument as is used to claim an automatic tendency to full employment, and depends on discredited notions such as a well-behaved demand function for aggregate ‘capital’ and conformity to Say’s Law.
Riedl ends the section on an ideological note:
In fact, large stimulus bills often reduce long-term productivity by transferring resources from the more productive private sector to the less productive government. The government rarely receives good value for the dollars it spends. However, stimulus bills provide politicians with the political justification to grant tax dollars to favored constituencies. By increasing the budget deficit, large stimulus bills eventually contribute to higher interest rates while dropping even more debt on future generations.
The claim that the non-government sector is more productive or efficient than the public sector is a statement of faith and nothing else. To take just one example, if this were true, US capital would want their economic interests in the Middle East enforced by a private military rather than an inefficient public one. When something really matters, government does it. Capitalists make sure of it. Optional extras can be left to the non-government sector.
Notice also Riedl slips in, at the end of the passage, the standard neoclassical assertions that budget deficits cause higher interest rates and impose a debt burden on future generations. The interest-rate assertion is completely without substance. Budget deficits in themselves put downward pressure on interest rates, compelling the central bank to intervene if it wants to maintain a target rate above zero. Bill Mitchell discusses this point here. Public debt poses no problems and need not even exist in a flexible exchange-rate fiat-money system.
Riedl goes on to consider arguments against his critique of government spending. There is little point responding, because his refutations depend on his arguments outlined above being valid, which they are not. But I will make one more observation. There is a lot of misunderstanding and mystification spread around when it comes to the connection between money and aggregate expenditure. Consider the quantity equation:
MV = PY
This is an accounting identity, true by definition. M, as before, is the quantity of money, usually defined for current purposes as currency plus demand deposits. V is the income velocity of money, meaning the number of times, on average, a unit of ‘money’ is involved in transactions over the economic period. P is the general (average) price level. Y is real output or real income. The identity simply says that the quantity of money times the average number of times a unit of money is used (MV) must, by definition, equal the total amount of money spent on goods and services (PY).
Riedl’s argument rests on several assumptions. M is assumed to be exogenously controlled by the central bank. V is assumed to depend on real factors and to be roughly constant. Y is assumed to be at the full-employment level in the long run. The last assumption is made because neoclassical theory says that the economy automatically tends to full employment, and will only deviate from full employment due to exogenous ‘shocks’.
Clearly, if M is exogenously controlled by the central bank, and V and Y are constants, as neoclassicals suppose, then the only possible effect of a change in M is an equiproportional change in P. Their theory says, in other words, that growth in the money supply has no effect on real output and simply causes inflation.
There are numerous problems with this argument. First, none of the assumptions even remotely hold. M is not – and cannot be – exogenously controlled by the central bank in a modern monetary system. V fluctuates. Y is hardly ever at the full-employment level, and has no automatic tendency to move to that position. Since M is not exogenously controllable, V fluctuates, and Y is variable, a change in M – for whatever reason – can be associated with any number of alterations in V, P and Y. When there is high unemployment, it is most likely that an increase in M will be associated with an increase in Y, with P left more or less unaffected.
Consider the notion that M can be exogenously controlled by the central bank. Neoclassical theory says that the central bank can do this by altering the amount of reserves in the banking system, which (according to the theory) will cause a multiplied alteration in M. If the central bank increases bank reserves, for instance, it is supposed that banks will decide they can lend more. The extra loans will go to people who spend, and this will cause increased deposits in the banking system (an increase in M).
But adding reserves does not induce more lending by banks. This should be clear from a decade of ‘quantitative easing’ in Japan and a couple of years of the same policy in the US and the UK Bank lending is not reserve constrained. Rather, it is constrained by demand from credit-worthy borrowers. If and when there are credit-worthy borrowers, banks will lend (credit bank accounts). Loans create deposits (M). So M is endogenously determined through the credit-creation process. But this increase in M does not represent a change in net financial assets. For every non-government asset created, there is an offsetting non-government liability. Horizontal transactions (those between non-government-sector participants) have no impact on net financial assets. Only vertical transactions (those between the government sector and the non-government sector) can alter net financial assets.
This raises the question of what creates more credit-worthy borrowers? The answer is stronger economic activity. When demand is strong, prospects for producers improve. Banks will then be more willing to lend. So if the government uses its capacity to net spend on goods and services, this induces an increase in output as firms produce to meet the government orders. The resulting sale of goods and services to the government puts income into the hands of firms and their employees who then have an increased capacity to spend on other goods and services or to increase saving to pay off private debts. Both outcomes are good when much of the non-government sector is deleveraging and swamped by debt. The sooner non-government debt is under control, the sooner consumers and firms can increase their expenditures and – if society wishes – the government can cut back its spending.
To illustrate how far off the mark Riedl is, consider the first paragraph of his section, “The Evidence is In”:
Economic data contradict Keynesian stimulus theory. If deficits represented “new dollars” in the economy, the record $1.2 trillion in FY 2009 deficit spending that began in October 2008–well before the stimulus added $200 billion more–would have already overheated the economy. Yet despite the historic 7 percent increase in GDP deficit spending over the previous year, the economy shrank by 2.3 percent in FY 2009. To argue that deficits represent new money injected into the economy is to argue that the economy would have contracted by 9.3 percent without this “infusion” of added deficit spending (or even more, given the Keynesian multiplier effect that was supposed to further boost the impact). That is simply not plausible, and few if any economists have claimed otherwise. (emphasis added)
Not only is the argument derided by Riedl as “implausible” completely plausible, but it is what happened. To avoid a decline in aggregate output, the budget deficit needs to offset the sum of the effects from net private saving behavior and international trade. This is one implication of the accounting identity:
Budget Deficit = Net Private Saving – Net Exports
Hypothetically, if private-sector saving intentions and international factors are such that, at current GDP, net private saving would be 5% of GDP and net imports would be 5% of GDP, then for GDP to remain constant, the budget deficit would need to be 10% of GDP.
Under these circumstances, if the government altered its fiscal settings in an attempt to reduce the budget deficit to a level less than 10% of GDP, the result would be a shortfall in demand and contraction in output and income. This would impact negatively on tax revenue and private saving (and also import spending). The budget deficit would still match the sum of net private saving and net exports, but at a lower level of output and employment.
Riedl is welcome to argue that the lower budget deficit will induce an increase in non-government expenditure that leaves overall demand and GDP unaffected, but if his argument depends on a monotonic inverse relation between the real general rate of interest and aggregate private investment, it is disqualified at the starting gate. Riedl has not provided any such valid explanation of how a smaller budget deficit could have no negative impact on aggregate demand and output, which is not surprising considering neoclassicals currently lack a valid macroeconomic theory. In any case, it is clear that non-government expenditure has not increased sufficiently to sustain full-employment output. To the contrary, non-government expenditure has remained weak, and will only be weakened further if the government attempts to impose austerity measures.
Leaving all that aside, consider what Riedl is actually proposing. He is calling for the government to “make room” (“room” that is available in any case) for private expenditure to take over from government expenditure at a time when the private sector is deep in debt. So his solution is for the private sector to go deeper into debt in order to drive renewed growth. This is an unsustainable path to recovery. The current private debt needs to be brought under control before the private sector can be the engine of growth.
Riedl and other right-wingers should really be proposing something else altogether: cancellation of private debts. This would remove the need for deleveraging, free up private income for expenditure, and reduce the need for government expenditure to prop up demand.