Government Spending, GDP and Nonsense In Between Them

No market news. Every market in Christendom was closed for the 25th.

Still, the crackpot theorists and muddled meddlers never seem to take a holiday. Robert Shiller should have been embarrassed to write the following words. The New York Times should have been embarrassed to print them.

But today’s economic intelligentsia knows neither shame nor common sense. You be the judge:

It has long been known that Keynesian economic stimulus does not require deficit spending. Under certain idealized assumptions, a concept known as the “balanced-budget multiplier theorem” states that national income is raised, dollar for dollar, with any increase in government expenditure on goods and services that is matched by a tax increase.

The reasoning is very simple: On average, people’s pretax incomes rise because of the business directly generated by the new government expenditures. If the income increase is equal to the tax increase, people have the same disposable income before and after. So there is no reason for people, taken as a group, to change their economic behavior. But the national income has increased by the amount of government expenditure, and job opportunities have increased in proportion.

Economists embraced this multiplier because it seemed to offer a solution to a looming problem: a possible repeat of the Great Depression after wartime stimulus was withdrawn, and when new rounds of deficit spending might be impossible because of the federal government’s huge, war-induced debt.

It turns out that this worry was unfounded. The Depression did not return after the war. But in the early 1940s, economists justifiably saw the possibility as their biggest concern. Their discussions have been mostly forgotten because they didn’t have much relevance for public policy – until now, that is, when we again have a huge federal debt and a vulnerable economy.

Okay. The feds spend more money and increase taxes to pay for the spending. This has a multiplier of “one” – or so they say – meaning, you get one times the benefit.

Why do we bother to challenge it? The idea is delusional claptrap. No need to shout it down. It whispers “nonsense” to anyone who will listen.

All we have to do is imagine what really happens:

A small, isolated town is in a slump. The mayor has read enough Keynes, Samuelson and Shiller to be dangerous. He increases both spending and taxes. He hires 20 people and raises taxes to pay their salaries. The 20 go to work, say, cutting the grass or painting the town hall. Now, they have income…which they spread among the town’s bars, brothels and banks. Presto! GDP goes up!

But where does the money come from? It comes from the taxpayers. On the one hand, the taxpayers have more – because the mayor is spending money. On the other, they have less, because taxes are higher. Since – in theory – they are only paying as much more in taxes as they receive in extra income, the lawn cutting and painting seems to be “free” extra GDP.

Wait a minute. If this were so, why not hire everyone in town and triple or quadruple taxes? Why not? Because it doesn’t work. It would only work – and only in theory – if the extra work undertaken by the government were equal in value to the work undertaken by the private sector. Otherwise, each person diverted out of the private economy merely becomes a zombie worker – producing something that may or may not be worthwhile.

What about just hiring the jobless people? That would increase income, right? And then you wouldn’t be taking anything away from the private economy, right?

Wrong. You still have to take away money. And if you raise taxes by the amount of money you put into the system, you are taking the money away from the private economy. The public sector grows, compared to the private sector. The gross amount of extra taxes may be no higher than the gross amount of extra spending, but the private sector surrenders more of its income in order to pay for the spending by the government.

Adding more zombies only makes it appear as though income has increased – as in a wartime, full employment economy. In fact, keep multiplying wealth according to the “balanced budget multiplier theorem” and you will soon have none left.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning