The abstract to Brian Riedl’s Heritage Foundation paper, ‘Why Government Spending Does Not Stimulate Economic Growth: 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 the arguments 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 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.
In a modern money system, government spending or lending logically must come first. Taxes and bond sales are only possible once government spending or lending has occurred. The currency-issuing government issues its money in the act of spending. The money the spending creates is in the form of reserve balances, held in special accounts at the central bank. Once created, these funds can be used to extinguish tax obligations or be exchanged for government bonds. Therefore, Riedl’s claim that “[e]very dollar Congress spends must first come from somewhere else” is incorrect. To the contrary, the funds used to pay taxes and purchase bonds come from prior government spending or lending. For instance, when the central bank, in the conduct of its monetary policy, enters repurchase agreements with primary dealers to neutralize the effects of a Treasury auction on reserve balances, the central bank advances reserves to non-government while requiring bonds as collateral. The reserves are newly issued government money, and the bonds the primary dealers put up as collateral only exist because of prior rounds of government spending. This point is discussed at considerable length elsewhere on the blog (at an elementary level in Fiat Money and its Social Significance; in much more detail in Exercising Currency Sovereignty Under Self-Imposed Constraints). In the present post, the focus is instead on Riedl’s denial that government net spending can affect total output and employment or “create new purchasing power”.
The claim that net government spending (government spending G > tax revenue T) has no impact on real output is only true when the economy is at full employment. Otherwise, government spending can be undertaken to purchase real goods and services from non-government. To meet this demand, non-government must increase output. The effect of taxation, in contrast, is to withdraw 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.
The claim that net government spending creates no new spending power is also false. We can look at this in two ways, either in terms of net financial assets or in terms of the quantity of money M (meaning reserves plus deposits).
Consider, first, the situation in terms of net financial assets, which are defined as the sum of currency on issue, reserve balances, and outstanding government bonds. When government net spends, it pays more into non-government bank accounts than it withdraws in taxes. There is a net increase in bank reserves held in the central banking system and a corresponding increase in bank deposits. Net financial assets held by non-government increase as a result. Any swap of reserves for government bonds, as occurs when banks enter a repurchase agreement with the central bank as part of the latter’s conduct of monetary policy, merely alters the form in which net financial assets are held. Overall, the government net expenditure adds net financial assets. This enhances non-government’s capacity to spend.
To see this more clearly, think of the reverse scenario of a government surplus (T > G). By Riedl’s reasoning, net taxing would have no impact on the amount of net financial assets held by non-government. But net taxation clearly will reduce net financial assets, and reduce non-government’s capacity to spend. A government surplus withdraws more funds from non-government bank accounts through taxing than it adds through spending. To make the net tax payments, non-government has to run down bank balances or sell bonds back to government in order to meet its tax obligation. The effect of the government surplus is therefore unambiguous: net financial assets decrease.
Now consider the implications of government net spending in terms of the quantity of money M. Viewed from this perspective, the effect of government net expenditure is to credit non-government bank accounts (through spending) more than they are debited (through taxing). This in itself will cause a build up of non-government bank deposits, which constitutes an increase in M. The precise final impact on M will depend on any swapping of reserves for bonds, and on who purchases the bonds. To the extent that bonds are purchased by banks, through the debiting of reserve accounts, this will have no implications for M, since reserves are not included in the definition of the broader money supply (i.e. M). But to the extent that bonds are purchased by the non-bank public, the effect is not only to drain reserves but also to reduce non-government bank deposits (which subtracts from M). The overall impact on M of government net expenditure is, at minimum, zero, which occurs in the unlikely and extreme scenario of all bonds being purchased by the non-bank public. In all other cases, the overall impact on M will be positive. In no case will the overall impact on M be negative, contrary to Riedl’s claim.
So, to summarize, we have an increase in real output Y as a result of the government net expenditure. We have an increase in net financial assets, whether held in the form of reserves, bonds, or some combination. And we have either no change in M (in the extreme case of no bank purchases of bonds) or an increase in M. In other words, government net spending causes an increase in real output and net financial assets without diminishing (and probably adding to) M. So the M available for purchases of goods and services remains undiminished or enhanced and, more importantly, net financial assets and real output have both increased.
Riedl’s mistakes on the points just considered mean that the rest of his argument breaks down, since they are contingent on government net spending having no impact on output or the spending capacity of non-government.
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.
Two points can be made here:
First, the funds do appear like “manna from heaven”. Money, whether government money, bank money or an individual IOU, is always created ex nihilo. That is how any financial liability is issued. It can only be issued by its issuer. Government money (defined as currency plus reserves) is issued in the process of government spending. A currency-issuing government, via instructions from its fiscal agent to its monetary agent, spends by issuing reserves, which injects additional net financial assets. Whether non-government subsequently alters the form of these financial assets is immaterial to the point at hand.
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 non-government from putting other idle resources to work. To the contrary, non-government now has more spending capacity than before, thanks to the positive impact of government net spending on its financial wealth.
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 resources are idle. If the government chooses to make use of some but not all idle resources, clearly there will still be idle resources left over that can be put to use within the non-government sector. Operation of a currency does not change this aspect of the problem one iota. If government uses its currency to activate some but not all idle resources, it in no way prevents non-government from utilizing the remaining idle resources. Again, the government’s net spending has left M either undiminished or enhanced and increased net financial assets held by non-government. In no way does this inhibit non-government’s command over resources.
Riedl’s argument obscures what is actually going on in terms of real resources.
Riedl then quotes 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 passage is problematic from the opening sentence for the simple reason that government spending always creates government money in the form of reserves, every time, no exception. There is no choice between issuing or not issuing money when the government spends. Government spending always issues new government money (reserves are created), just as taxation always destroys government money (reserves are deleted from the system). This is true whether, alongside the government spending process, reserves are converted to bonds or simply left as reserves, a matter which will depend on the central bank’s preferred conduct of monetary policy (method of interest-rate setting) and have nothing to do with the government’s capacity to spend or the effects of its spending on the real economy. If the central bank pays the policy rate (possibly zero) on reserves, there is no need to convert reserves to bonds. The reserves can just be left to mount in reserve accounts. Otherwise, the central bank adds and drains reserves at various times to maintain interest-rate stability. Whether non-government holds its extra net financial assets in reserves or bonds, its capacity to spend is enhanced.
Since government spending always creates government money, the remainder of the passage is incorrect whenever the economy is operating below full employment. Whenever this is so, it is possible to produce more roads and more factories. Cochrane may as well say that if the private 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.
There is a further serious problem with the argument put forward by Cochrane and embraced by Riedl:
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 passage erroneously equates saving with investment. The implicit claim is that every act of saving is inevitably also an act of investment. Saving, or so it is supposed, calls forth investment. This claim has a name: Say’s Law. It was discredited first by Marx, then by Keynes and Kalecki, and later from within neoclassical theory itself. Some on the right wing of neoclassical economics continue to hold to the alleged law in the ‘long run’, but even on neoclassical grounds there is no justification for the idea in view of well known results established in general equilibrium theory. For those whose arguments implicitly rest on Say’s Law, the effects of a collapse in consumption will supposedly be nullified by a rise in investment, induced by lower interest rates. For some of the more extreme proponents of this view, who were quite vocal prior to the global financial crisis and Great Recession, the economy need not even deviate from full employment during a switch from consumption to investment. If it does, it is only because individuals commit random expectational errors that cause, to take one example, workers to demand higher wages than are consistent with their continued employment, resulting in layoffs.
There is no legitimate basis for this line of reasoning and is partly what the capital debates were about (discussed in Nobel-nomics). First, it is a fallacy of composition to suppose an inverse, monotonic relation between the real rate of interest and aggregate private investment. Paul Samuelson, probably the leading neoclassical economist of the twentieth century and a chief participant in the debate, explicitly acknowledged this point in his famous ‘summing up’. An implication that directly follows is that, until established otherwise, Say’s Law cannot be said to hold, in the long run or otherwise. Second, it is invalid to suppose, in general, that a reduction in real wages will translate into higher aggregate employment. This, too, is a fallacy of composition, and another casualty of the capital debates. It is also a casualty of aggregation problems uncovered later by neoclassical general equilibrium theorists.
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 implicit claim in this passage is that growth is supply determined. There is an assumption that actions which 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 private sector is more productive or efficient than the public sector is a statement of faith and nothing else. But leaving that to one side, a couple of observations can be made. One observation is that leaving resources idle is not productive, so the bar is exceedingly low when it comes to finding better uses for those resources. Utilizing resources in the public sector that otherwise would be left idle enhances allocative efficiency and adds to output. Another observation is that productivity behaves procyclically. Productivity will improve more rapidly in a high-demand, ‘high-pressure’ economy than in a low-demand, ‘low-pressure’ economy. In the latter, unemployment is high and organized labor weak, meaning that profit maximization can be pursued through wage reductions rather than productivity improvements and enhanced technical efficiency. In a high-pressure economy, in contrast, the onus is on productivity growth and efficiency gains through technical and organizational innovation.
Riedl also asserts, at the end of the passage, that government spending in excess of taxation causes higher interest rates and imposes a debt burden on future generations. The interest-rate claim is without substance. Government spending in itself, by causing an influx of reserves, puts downward pressure on interest rates, compelling the central bank to intervene (either by selling bonds or paying interest on reserves) if it wishes to maintain a positive interest rate. Bill Mitchell discusses this point here. The depiction of public debt as a burden on future generations is also without substance. Public debt, as a matter of accounting, is just the flipside of the non-government’s accumulated financial wealth. It does not carry an intergenerational burden for countries that have their own currencies.
Riedl, in the remainder of his paper, goes on to anticipate some possible arguments against his critique of government spending. There is little point responding to these, because his refutations depend for their validity on his prior claims (already addressed above) being correct, which they are not.