12/29/2012 04:07 pm ET | Updated Feb 28, 2013

The Keynesian Stimulus Spending Fallacy

It's a truism of pop Keynesian economics that consumer spending drives the economy; if spending slows in a recession, government must make up the difference. In reality, consumer spending merely signals what consumers want; producers may be unable or unwilling to deliver. Government spending may compensate -- or make matters worse -- depending on the type of spending and whether it's financed by progressive taxes or by borrowing.

The logic of spending runs loosely as follows: I spend $1 at the grocery store. The grocer spends $.80 of that at the gas station. The gas station owner spends $.80 of that at the barber, and so on. By the logic of an infinite series, my one dollar in spending has generated an additional $4 dollars in spending; or the "multiplier" is 4. And with that additional spending comes another $4 in production. However if I leave that dollar in the bank, and the bank doesn't lend it to someone else to spend, then government must spend it to keep the economic machine running. Sounds plausible, doesn't it?

But there's a weak link: the assumption that spending automatically leads to production and jobs.

Consider a small businesswoman. She manufactures wooden jig-saw puzzles. Every month she decides how many puzzles to make, and hence how many hours to schedule for her employees. What does she consider? First, she estimates her next month's sales from sales last month and previous months. That is, she plans how much to produce based on consumer spending. But then she considers how much cash she has available to pay for plywood and workers' wages. Small businesses often operate on lines of credit, borrowing each month for payroll and materials, paying back loans with cash following sales. If -- as happens in a recession -- banks reduce credit and customers delay paying, our puzzle-maker cuts back planned production and lays off workers.

Now consider a large profitable conglomerate, an aggregation of dozens of businesses and thousands of products. Such an enterprise faces no shortage of cash in a recession (see my last post on cash-hoarding multinationals). But management turns cautious. It shuts down less profitable business lines and lays off workers, even when there's still substantial demand. Likewise big banks turn cautious, denying credit even to steady customers like our puzzle-maker.

In short, when a recession makes cash tight for small business, and confidence low for large business, consumer spending does not translate into production and jobs.

Can government spending nonetheless create production and jobs to replace those lost in a recession? That depends first on the type of spending. Military spending is the worst. First it creates very few jobs per dollar spent; second, it creates limited (or negative) benefits. Contrast that with urban services: street and sewer repair, garbage collection, schools, police, fire, welfare and health provision -- all of which create many jobs per dollar spent. Add in Federal safety-net spending -- notably Social Security, Medicare, Medicaid, and unemployment insurance. Without these services operating invisibly in the background, neither the puzzle-maker, nor the conglomerate, nor their customers would survive. Here's where government should spend more during a recession, not cut back. (This does not justify highways and bridges to nowhere, which don't rate much above military spending.)

The effectiveness of government spending also depends on how it's financed. Local government services raise property values; when property owners pay property taxes, they pay for benefits received. However excessive borrowing undermines benefits of government spending. I've dealt with this at length in Deficit Hawk, Progressive Style, Parts I and II.

It's a harmful myth that spending drives the economy. It makes us think we can rev up the economy by any old government spending, financed any old way. In reality, we need productive, job-creating, service-providing government, supported by progressive taxes.