Since the Great Recession began in 2008, the federal government has tried to ‘stimulate’ the economy by spending more money. It’s one reason why the budget deficit has been over $1 trillion dollars for the last few years. The rationale is that an increase in government spending can make up for any lack of spending by consumers and businesses. If the level of government spending is higher than the shortfall in consumer and business spending, then national income, or Gross Domestic Product (GDP), will increase. When GDP increases, the economy is thought to be expanding and the citizens of the country will enjoy a higher standard of living.
Where did the government get the idea that increases in government spending can help the economy? Why, from an economist of course! In his book The General Theory of Employment, Interest, and Money, Lord Keynes wrote that the level of national income can be computed by adding together all expenditures in the economy. He listed four categories of expenditures:
Consumption (C) – the expenditures by households on durable goods, non-durable goods, and services.
Investment (I) – the expenditures by businesses on new capital goods like buildings, machinery, and equipment.
Government spending (G) – all expenditures of government.
Net Exports (X-M) – the difference between the value of Exports (goods made here but sold overseas) and Imports (goods made overseas but purchased here).
According to Keynesian economists, GDP = C + I + G + (X – M). If this is true then any increase in spending by the government will result in a higher level of GDP and citizens will be better off. But there is something missing from this formula. No one asks this important question: where does the government get the money that it spends to stimulate the economy?
The government has no money of its own. It doesn’t earn anything that it spends. The government has only three ways to get money: taxation, borrowing money by selling government securities, or printing money.
Government spending is already represented by G. If we represent the money collected by Taxation with T, the amount of money borrowed by B, and the money that is printed with an M, then G = T + B + M. In order to increase G, we must either 1)increase T; 2) increase B; or 3) increase M.
If the government chooses to increase the level of taxation, then consumers will have less money available to spend or save, and businesses will have less money to use to build new factories or buy new machinery and equipment. In this case, an increase in taxation will result in a decrease in Consumption, a decrease in Investment, or a decrease in both Consumption and Investment. Thus, an increase in Taxation may result in a decrease in GDP. Mainstream economists argue that the effects of an increase in taxation are offset by the subsequent increase in government spending. This is true if the government increases spending by the same amount as the increase in taxation (G = T). However, now C = Consumer Income – Taxation and I = Business Investment – Taxation. In the best-case scenario, the increase in government spending will be equal to the decrease in Consumption and Investment spending. In any other scenario, the increase in Government Spending and Taxation will actually reduce GDP.
Let’s try option number 2. If the government decides to finance an increase in spending by borrowing the money, then the decline in Consumption and Investment spending seems to be avoided. But there are two things that may not be realized in this case: 1) the government has to pay interest on the money that it borrows, and 2) the government has to repay the principal amount at the maturity date. And where will the government get the money to pay back this principal and interest? By either increasing taxes, borrowing more money, or printing money. While borrowing money may allow for more government spending now, it will result in less government spending in the future. Borrowing will also result in less Consumption and Investment spending in the future. Once again, government spending results in a decrease in GDP, only this time it is future GDP and not current GDP.
Hrm again. So far, increasing taxes and borrowing money will result in a lower level of GDP in the future. Oh well, the government still has the option to print money instead of increasing taxes or borrowing money. So what happens when the government prints money in order to increase spending?
When the government prints money, it spends it on goods and services at the current price level. When this new money enters the monetary system as it is spent, it results in a decline in the purchasing power of all the other money previously in circulation. In order to maintain the same level of purchasing power as before, everyone in the economy will increase the price of the good or service that they are selling. When all of these prices rise, consumers will have less income available to spend and Consumption will decrease. Businesses will also have less income available to spend, and won’t be able to spend as much on Investment as they did before; Investment will also decrease. And if the increase in Government Spending does not offset these decreases in Consumption and Investment, GDP will fall when the government borrows money.
Increases in Government spending do not result in increases in GDP; they actually result in decreases in GDP. And increasing taxes, borrowing money, and printing money do more damage to the economy than the government cures by spending the money raised in these ways.