When signs of an economic weakness emerge, most “experts” are quick to recommend fiscal and monetary stimulus. Economic activity is presented in terms of the circular flow of money—spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.
If, for some reason, individuals decide to reduce their spending, this would weaken the circular flow of money. Once an individual spends less, this worsens the situation of some other individual, who, in turn, also cuts spending. Following this logic, in order to prevent the effects of a recession, the government and the central bank should step in and raise government outlays and inflation, thereby filling the shortfall in the private sector spending. Allegedly, once the circular monetary flow is reestablished, things should go back to normal and sound economic growth is also reestablished.
Can government grow an economy?
The whole idea that government can grow an economy originates from the Keynesian multiplier. This asserts that an increase in government spending raises an economy’s output by a multiple of the initial government increase. For example, let us assume that, out of an additional dollar received, individuals spend $0.90 and save $0.10. Also, assume that the government increased its expenditure by $100 million. Individuals now have more money to spend because of increased government spending.
Because of this, retailers’ revenue rises by $100 million. Retailers, in response to this increase in their income, consume 90 percent of the $100 million (i.e., they raise expenditure on goods and services by $90 million). The recipients of these $90 million, in turn, spend 90 percent of the $90 million (i.e., $81 million). Then, the recipients of the $81 million spend 90 percent of this sum ($72.9 million), and so on. The key in this model is that expenditure by one individual becomes the income of another individual.
At each stage in the spending chain, individuals spend 90 percent of the additional income they receive. This process eventually ends, so it is held, with the total output higher by $1 billion (10*$100 million) than it was before the government had increased its initial expenditure by $100 million. The more that is spent from the additional income, the greater the multiplier is going to be and, therefore, the impact of the initial government spending on overall output is larger. For instance, if individuals change their habits and spend 95 percent from each dollar the multiplier is going to be 20. Conversely, if they decide to spend only 80 percent and save 20 percent then the multiplier will fall to 5. All this implies that the less is saved the larger the impact of an increase in government outlays on overall demand and on overall output.
Assuming these things, it is not surprising that most economists today are of the view that fiscal and monetary stimulus can prevent the US economy falling into a recession. The popularizer of the magical power of the multiplier, John Maynard Keynes, wrote,
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.
More Government Spending ≠ More Saving
Let us examine the effect of an increase in the government’s demand on an economy’s process of saving formation. In an economy, which is comprised of a baker, a shoemaker and a tomato grower, another individual enters the scene. This individual is an enforcer who exercises his demand for goods by means of force. The baker, the shoemaker, and the farmer are forced to part with their products in exchange for nothing and this, in turn, weakens the flow of production of consumer goods. Similarly, not only does the increase in government demand—the increase in the enforcer’s demand—not raise the overall output by a positive multiple, but, on the contrary, this leads to the weakening of the process of saving in general.
By means of taxation and borrowing, the government forces producers to part with their products for government services (i.e., for goods and services that are likely to be on a lower priority list of producers) and this, in turn, weakens the overall production of wealth. According to Mises,
As against these popular fallacies there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.
What causes recessions?
For most commentators, the occurrence of a recession is a result of unexpected events such as shocks that push the economy away from a trajectory of stable economic growth. Shocks weaken the economy (i.e., cause lower economic growth).
In reality, as a rule, a recession emerges in response to a decline in the growth rate of money supply, after a prior prolonged period of inflation. A recession often follows a tighter monetary stance of the central bank, that is, when inflation of money and credit slows. Thus, various activities that sprang up during the previous inflationary period come under pressure. These activities cannot support themselves. They only survive because of the inflationary support that increases in money supply provided. The artificial increases in the money supply diverts production away from genuine wealth-generating activities. Consequently, this weakens such wealth-generating activities.
Because monetary authorities cannot inflate endlessly (without destroying the monetary economy), they eventually tighten their monetary stance. As a result of the tighter stance and a consequent fall in the growth rate of the money supply, this undermines various non-wealth-generating activities and this is when a recession takes place.
Given that, non-wealth-generating activities cannot continue to support themselves, since they cannot continue to be profitable once the growth rate of the money supply declines, these activities begin to deteriorate. Recession, then, is not about a weakening in economic activity as such, but about the liquidation of various non-wealth-generating activities that sprang up on the back of artificial increases in money supply.
Obviously then, both aggressive fiscal and monetary policies, which are going to provide support to non-wealth-generating activities, are going to further distort the price and production structure, thereby weakening the prospects for a meaningful economic recovery. Hence, once an economy falls into a recession, the government and the central bank should restrain themselves and do nothing.
Artificial fluctuations in the growth rate of the money supply always set in motion the phenomenon of boom-bust cycle. Increases in the money supply diverts production and saving from wealth-generators to non-wealth-generators. This causes artificial growth in these areas of production, made possibly by inflationary policies. Consequently, a decline in the money supply growth rate reveals these distortions and—because these companies must now decline or be liquidated—this leads to other economic issues (business failures, unemployment, etc.). Hence, it is the monetary and fiscal policies of the central bank that set in motion the boom-bust cycles. Whenever the central bank monetizes government outlays, this leads to the so-called economic “boom,” that is, an artificial boom. Once the pace of government spending and monetization slows, there will be an economic bust.
Conclusion
During an economic crisis, governments and the central banks should do as little as possible. With less tampering, more prices and production can come into market alignment, the errors in the structure of production can be liquidated, more savings can be generated, and saving and capital investment can be directed toward true wealth-generators. This would lay the foundation for a durable economic growth.
