Fiscal stimulus is centered on boosting aggregate demand. In economics aggregate demand is defined as the total demand for final goods and services at a given price. Demand itself is the number of people who are both willing and able to purchase final goods. By spending money on public works and investing in private companies, the government feeds money into the economy and the pockets of consumers. This increases their ability to spend on final goods, thereby enriching the producers of those goods who will in turn enrich those that they buy from themselves, leading to an overall increase in productivity. In theory, a certain increase in government spending can lead to a larger increase in overall productivity.
In February of 2009 the Obama administration signed the American Recovery and Reinvestment Act, a combination of tax cuts, welfare and grants and contracts for private businesses with the goal of creating or saving jobs and spurring economic growth. According to Recovery.gov, the website tasked with providing information on the stimulus to the public, the bill cost $787 billion in deficit spending. At that time unemployment continued to climb as GDP fell. Today, while GDP is no longer falling, unemployment remains above 9%.
The idea that government spending can be used to boost the economy out of a recession is based on flawed economic thinking and has likely done real harm to the economy.
In order for the government to spend, it must first destroy wealth either through taxation or inflation. In order to spend $787 billion, the government must first come up with the money by either increasing taxes, printing more money and inflating the currency, or borrowing (which will have to be paid for by one of the former methods at a later date). The first flaw of stimulus spending is that it ignores the hidden cost of spending and focuses only on the visible results it produces. While it is true that government money is building bridges, paving roads and creating jobs in targeted industries, those benefits must be weighed against the opportunity costs incurred by destroying the wealth of private individuals and businesses. This cost is the potential investments that would have been made if the government hadn’t taxed or inflated away their wealth, such as business ventures, new cars or higher education.
The classic example of this comes from the French economist Frédéric Bastiat and his parable of the Broken Window. Bastiat presents the example of a boy breaking a shopkeeper’s window. As the gathering crowd discusses the matter, they come to the conclusion that the boy, rather than doing damage, has actually benefitted society. Now the shopkeeper must pay the glazier to repair his window, and the glazier is enriched and can now purchase goods from someone else. Bastiat acknowledges that all of this is correct, but points out that it is a mistake to think that the town experienced a net gain in productivity or wealth. Because the shopkeeper had to pay the glazier, that money could not be put to any other use. Now he only has the window, whereas before he could have had the window and a good equal to the cost of the glazier’s services. Essentially, you can’t create wealth by destroying it first.
The second problem with stimulus spending is one of incentives. In the private sector individuals control how their money is spent. They must take responsibility for all the risks associated with their purchases and investments, which provides an incentive to spend carefully. When someone is thinking about buying a car they want to make sure that there is nothing wrong with it before they make their purchase. They know that they can’t waste money on a vehicle that breaks down as soon as it leaves the lot, so they are careful with how their money is spent. The same holds true for entrepreneurs and investors. They will do extensive research to determine if a new enterprise can be profitable before they risk their money on it. Should it fail, they will have to bear the consequences.
This is not the case with government. As I stated earlier, the government has no money of its own. All of it comes from taxpayers. When the government spends money it doesn’t assume the same risks as a private individual, namely because the money wasn’t theirs to begin with. The incentive that ensures the careful use of capital by private individuals doesn’t exist for the government. As a result it can spend recklessly, wasting taxpayer dollars on pet projects for congressmen to brag about in their districts and shaky investments in politically favored firms like Solyndra. Government projects are often marked by the excessive price tag attached to them. Without the risk that normally attends private sector investment, the government is particularly prone to make risky and wasteful investments.
Stimulus spending takes money away from private individuals through taxation and places it in the control of congressmen and bureaucrats who lack the incentive to invest it well. Not only is such a policy wasteful, it stalls real growth by limiting private sector investment. Every grand government scheme must be scrutinized for the unseen opportunity costs it creates and the incentive structure that is at work.