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Why Public Spending does not Stimulate the Economy


Student Guest

By

June 17th, 2012


A common misconception is that increases in government spending will stimulate the economy.


By Collin Li

A common misconception is that increases in government spending will stimulate the economy. The logic offered to support this argument often describes how government spending will end up being paid as income to either business owners or workers, who will then spend a portion of that extra income, which will then become somebody else’s income and so on, causing the money to cycle through the economy, and create a multiplier effect and hence creating wealth and stimulating the economy. There is nothing wrong with this logic, but it doesn’t quite justify public spending.

It’s easy to see the multiplier effect in action as the government injects dollars into an economy. Our companies will make more sales, which encourages higher production schedules, encouraging employers to create more jobs. As a result, there will be higher levels of GDP and lower levels of unemployment. So what is there to complain about? There are hidden costs. Consider: where did that money come from?

It came from taxpayers. Taxpayers who would have used the money according to their own preferences and needs, directing the market to produce the goods and services that are the highest priority to these taxpayers. Additionally, these private spending patterns would cycle through the economy, like with government spending, creating the same benefits that government spending would. The difference, however, is that the economic activity spurred by private spending will signal the market to produce the goods and services that people actually need, rather than on what the government spends on behalf of the people.

Think about two possible ways that money can be spent:

1. Your money can be spent on yourself.
2. Someone else’s money can be spent on someone else.

The first option is like most typical private spending habits. You spend your own money on yourself. Since you are spending your own money, you take care of how much you spend, keeping consideration of your limited resources. Additionally, since you are spending the money on yourself, you make sure you get goods and services that are important to you. Overall, this type of spending prevents waste, and guides the market to produce the goods and services that are important to society.

The second option is like most government expenditures. Someone else’s money is being used on someone else. It’s not your money (mainly), so you don’t really care about how much you spend, and it’s not being spent on you (mainly), so you don’t really care what it’s spent on either. This type of spending encourages waste, and haphazardly directs the market to produce goods and services that may not be beneficial to society.

So when government spends, it forgoes the opportunity of the far more efficient type of spending: private spending. Government spending joins the list of the many other “beneficial” programs where government intervenes, and unlocks steep hidden costs as an unintended consequence. It’s not easy to envision the loss of government spending, as it improves GDP and lowers unemployment. However, private spending does it better, and by spending through the public treasury, we sacrifice the better option.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

  • Brendan

    Kevin Murphy from the University of Chicago has a pretty good framework: http://faculty.chicagobooth.edu/brian.barry/igm/Evaluating_the_fiscal_stimulus.pdf

  • Lolimar

    I don’t quite follow what the contention of your article is.

    1.) What do you mean by public spending? Are you talking about money handouts in particular (eg: Gillard’s school bonuses, or Rudd’s stimulus during that Christmas of 2008 I think it was? )? Or are you including spending on public services and everything else the government spends money on.

    2.) Government spending might be inefficient, but I think it’s a bit strong to say it has no effect either.

  • Tristan

    Of course, you can make the argument that public spending would provide no greater stimulatory effect if this spending was simply replacing efficient private consumption (you are assuming that the money people saved on paying taxes would be used for private consumption). However, if the taxes that were used to pay for stimulatory activity were revoked – how do we know if people would save this additional income or spend it?

    This is where Keynes comes in (and where the Chicago School departs). It is wrong for that particular school to assume people are prophetic or know the future and to not be uncertain. In the real world crises of confidence exist and Government spending will be stimulatory when people are saving a far greater proportion of their incomes or deleveraging. For instance, this is what has happened over the past 20 years in Japan as people have had to delever following the excesses of the stock/property bubbles of the 80s where the Government has stepped in for more than two decades to prop up aggregate demand.

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