Frank Shostak
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.
Yes, the busts in the boom-to-bust business cycle are the healing points for the economy. This is what the monetarists and Keynesian’s want to avoid. They want to keep pumping the fantasy economy for things people do not really want, or to say it properly, are not very high on their list of priorities. The bust clears all the dross and Malinvestments out of the economy to correct the problems made by state interventions. FTS!