Government in Macroeconomic Perspective


A nation’s aggregate economic activity usually is measured by its Gross Domestic Product (GDP). I accept GDP as an aggregate, monetary measure of national output. But it is impossible to sum the true value of the myriad economic transactions that GDP is supposed to represent because each transaction means something different to the participants in the transaction; that is, the true value of economic goods is subjective. (See, for example, Peter Boettke’s “Austrian School of Economics,” at The Concise Encyclopedia of Economics., and my posts, “Subjective Value: A Proof by Example” and “Microeconomics and Macroeconomics.”)

GDP, nevertheless, affords a rough measure of the general level of a nation’s material well-being. All things being the same, a large fraction of a nation’s citizens — but certainly not all of them — will be better off materially if GDP is growing and worse off if it is shrinking. But no one who is paying attention to the state of the nation should mistake material progress for real progress. (See, for example, “I Want My Country Back.”)

The usual way of representing GDP is called the expenditure method. In simple form, it expresses GDP this way:

GDP = private consumption + gross investment + government spending + (exportsimports), or

GDP = C + I + G + (X – M)

Note: “Gross” means that GDP measures production regardless of the various uses to which that production can be put. Production can be used for immediate consumption, for investment in new fixed assets or inventories, or for replacing depreciated fixed assets. “Domestic” means that GDP measures production that takes place within the country’s borders. In the expenditure-method equation given above, the exports-minus-imports term is necessary in order to null out expenditures on things not produced in the country (imports) and add in things produced but not sold in the country (exports). (Taken from “Gross domestic product” at Wikipedia. See also Mack Ott’s “National Income Accounts” at The Concise Encyclopedia of Economics.)

This equation has become so familiar that its correctness is taken for granted. But a bit of reflection reveals it as a model of inconsistency. The dichotomy between consumption and investment is sensible. But the goods acquired and sold in international trade are of the same two types; there is no reason to segregate them from consumption and investment. This is especially true because the sum of consumption and investment is greater than it would be in the absence of international trade. Government, on the other hand, is a net consumer of economic output, not a net producer of it, as the “+ G” term might suggest.

With that background, I will offer an alternative to the standard expenditure method of describing GDP. The journey is step-wise: from a closed economy without international trade or government to an economy with international trade, but without government, to an economy with both international trade and government. Along the way, I fully acknowledge the importance of government as a contributor to GDP, as long as its role is to foster beneficial exchange by maintaining the rule of law and defending Americans from predators, at home and abroad.

That said, government activities (as reflected in total government spending) have led to an economy that produces a small fraction of its potential output. And yet, the true believers in big government seek to make it larger and ever more destructive. I expand on these points at length in Part II, An Alternative Expenditure Model; Part III, The High Cost of Big Government; and Part IV, The Heart of the Problem: Big-Government Worship and Pseudo-Intellectualism. (Continued below the fold.)


A. Closed Economy with No Government

Here is the equation for a closed economy (no international trade) with no government:

(1) GDP′′ = C′′ + I′′ = C′′ + S′′

GDP′′ = gross domestic product; the value of new goods produced during a year (including new goods in intermediate stages of production at the end of the year, but excluding depreciation of goods produced in previous years);
C′′ = goods currently consumed by spending income and gifts derived from private-sector activity;
I′′ = investment in capital used by private-sector entities in the production of goods, and in inventories of goods still in production or ready for sale but not yet sold; and
S′′= saving, which must equal investment in the absence of government and international trade.

 B. The Economy with International Trade

Next is the equation for an economy with international trade, but no government. The most important thing about international trade is that it is essentially the same thing as inter-State, inter-city, and inter-block trade: It is undertaken for the mutual benefit of the parties involved. In essence, trade across international borders is no different than trade between a garage mechanic and a grocer who live in the same town. (See, for example, my post, “Trade.”)

International trade involves the voluntary reduction of C′′ and I′′ in exchange for consumption and investment goods having a somewhat different — and preferable — composition. The C′′ and I′′ diverted to international trade are called exports (X). The goods received in exchange are called imports (M).

If X were always equal to M, the equation for GDP would be straightforward:

(2) GDP′ = C′ + I

where the single-prime symbol () denotes GDP and its components, with international trade.


(3) GDP′ > GDP′′

But X and M are not always equal. In fact, the usual case for the U.S. is M>X, which economic illiterates decry because the inequality is called a trade deficit. Not all deficits are bad, however, and the so-called trade deficit is an example of a potentially beneficial deficit. Further, it is not really a deficit.

When M>X, foreigners finance the difference by purchasing the debt and equities of U.S. entities. If they did not, M would shrink to X and GDP′ = C′ + I would be smaller by the amount of the reduction in M. A so-called trade deficit can be expressed as follows:

(4) M – X > 0, M = X + Ff

where Ff = net foreign financing of the portion of C′ + I attributable to M – X, in exchange for claims on future U.S. output (through the purchase of U.S. debt and equities).

To the extent that the claims represented by Ff flow to I, this fosters economic growth in the U.S., which benefits Americans and foreign exporters.

Analogous to (4), we have:

(5) X – M > 0, X = M + Fd

where Fd = net U.S. financing of the portion of C′ + I attributable to X – M, in exchange for claims on future foreign output (through the purchase of foreign debt and equities).

To the extent that the claims represented by Fd flow to investment in other countries, this fosters economic growth in those countries, which benefits foreigners and American exporters. In other words, Fd represents an investment in future production, just as if it were a component of I.

It follows from the discussion of (4) and (5) that the volume of foreign trade that yields (3) is the greater of X or M:

(6) GDP′ > GDP′′= f(max[X,M])

Finally, equations (4) and (5) remind us that trade, whether it is inter-block, inter-city, inter-State, or international, is a positive-sum exchange. And (6) tells us that (3) holds true whether there is a so-called trade deficit or a so-called trade surplus.

C. The Effects of Government

We come now to government spending, which – beyond a certain level — does not increase GDP, but generally redistributes and decreases it. (This is an empirical statement, evidence for which I discuss below.) Government spending is beneficial up to the point where it becomes a drain on GDP; that is, at the point where government exceeds a minimal, protective role and acts in ways that discourage productive effort.


(7) GDPmg ≥ GDP

where GDPmg  = an economy with international trade and just enough government (minimal government), so that GDP is greater than or equal to what it would be in the absence of government.

In the following discussion I use three closely related terms:  Ga, G, and $Ga.

Ga represents governmental activities, not all of the costs of which are reflected in official estimates of GDP (e.g., the substantial but hidden burden of regulation). Governmental activities are of five broad types:

  1. transfer payments to individuals (e.g., Social Security), which impose costs because the payments transfer income to those who did not earn from those who did;
  2. de facto transfer payments, namely, the compensation of government employees, and the compensation that flows to the employees, shareholders, and creditors of government contractors – all of which must be financed by private-sector entitites;
  3. purchases of consumables and capital that are used directly by government in the provision of government services (e.g., fuel for government vehicles, electricity for government buildings, government vehicles, and government buildings);
  4. the continuation, initiation, modification, and enforcement of tax codes, regulations, administrative procedures, statutes, ordinances, executive orders, and judicial decrees; and
  5. the financing of items 1 – 4.

Now comes G (in bold italics), with which I denote spending on those resources that are actually depleted (immediately or over time) in the production of government services. Thus G excludes items 1 and 2: transfer payments and compensation for the services of individuals (salaries, wages, benefits) and firms (profits and fees above the cost of materials used in or delivered to government). Such compensation should, properly, find its way into the GDP equation in the form of Cand I, that is, private-sector consumption and investment. The G term represents only those resources that end up in the hands of government, through the actions encompassed in items 3 and 4.

This brings us to $Ga, which represents the observable cost of Ga, including items 1 and 2, even though they flow into private-sector consumption and investment. Although $Ga does not include indirect costs, such as those that are imposed by the regulatory burden, it is a useful measure that comes into play when I estimate the effect of government on economic growth. Today (and for more than a century), most of the activities in items 1-4 represent government on a scale that far exceeds, in cost and scope, the kind of government that is meant by GDPmg.

The relationship between Ga, G, and GDP is not straightforward. For example, the net effect of items 1 and 2 is almost certainly a reduction of GDP. Why? The diversion of income to the unproductive (e.g., persons on Social Security) and counterproductive (e.g., government employees who write and enforce regulations) – by whatever means (taxing or borrowing) is bound to disincentivize work, saving, innovation, and investment. That causes GDP to be lower than it otherwise would be, but the effect is multiplicative, not merely a matter of addition or subtraction. (A Keynesian would argue that the actions encompassed in item 1 tend to raise GDP because the recipients of nominal transfer payments probably have higher marginal propensities to consume than do the persons from whom the transfer payments are exacted. This facile claim overlooks the disincentivizing effects of taxation on the more productive components of an economy, and on the resulting reduction in work effort and growth-producing investment.)

Similarly, the diversion of resources to items 3 and 4 cannot be thought of as additions to or subtractions from GDP, but as multiplicative, because of the same kind of disincentivizing leverage. For example, one effect of item 4 is the unobserved but very real burden placed on the private sector by federal regulations. It has been estimated, reliably, that those regulations impose a hidden cost greater than 15 percent of GDP. (See Nicole V. and W. Mark Crain’s “The Impact of Regulatory Costs on Small Firms,” prepared for the Small Business Administration’s Office of Advocacy, September 2010.)

Then there is item 5: financing. Taking $Ga as the total measured cost of governmental activities, we have:

(8) $Ga = T + L

T = taxes exacted from private-sector entities (including spending that is financed by money created by the Fed); and
L = new government borrowing (loans from domestic private-sector entities and foreign entities).

Consider these limiting cases:

1. $Ga is financed entirely by T levied on entities within the U.S. Taxes discourage work and investment. They do so directly because taxes diminish the returns on work and investment, even when the taxes are levied indirectly. (For example., the Social Security tax “paid” by employers acts to diminish employees’ compensation by reducing the demand for labor.) T therefore has a strongly negative multiplier effect, which has been estimated with some certainty. (See Christina D. and David H. Romer’s “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,”  Working Paper 13264, National Bureau of Economic Research, July 2007.) An increase in $Ga that is financed by the tax known as “deficit spending” (i.e., money creation) similarly– but more subtly — diminishes the returns on work and investment, even as it fails to stimulate the growth of GDP. (See, for example, my posts “
Ricardian Equivalence Reconsidered,” “Does World War II ‘Prove’ Keynesianism?,” “A Keynesian Fantasy Land,” “The Keynesian Fallacy and Regime Uncertainty,” “Why the “Stimulus” Failed to Stimulate,” “Regime Uncertainty and the Great Recession,” “The Real Multiplier,” and “The Real Multiplier (II).”)

2. $Ga is financed entirely by L, and the source of L is entirely domestic. A naïve reaction to this possibility is that it is benign because L is voluntary. But the fact that lending is voluntary, in contrast to the payment of taxes, does not matter. What matters is the diversion of resources from voluntary, mutually beneficial, private-sector transactions to governmental uses. Those uses are decided by officials who are elected by simple majorities of voters (who constitute minorities of the numbers of persons affected by government); by officials who are appointed by those elected officials to long (sometimes lifetime) sinecures; and by unelected, hard-to-fire civil “servants,” who are inherently interested in the continuation and aggrandizement of their respective bureaucracies. There is nothing remotely efficient about decision-making that is undisciplined by market forces and barely affected by changes in the names and parties of elected officials. (It should be obvious — but sadly is not — that $Ga is, to a great extent, inimical to liberty. But I will not get into that issue in this post, except to note that constraints on economic activity, which accompany Ga are also constraints on social freedom. See my posts, “The Indivisibility of Economic and Social Liberty” and “Our Enemy, the State.”)

3. $Ga is financed entirely by L, and the source of L is entirely foreign. In this case, the diversion of foreign lending to U.S. governments displaces X, and thus the enjoyment by Americans of M financed by X. Foreign lending to U.S. governments also diminishes the flow of investment funds from foreign sources, thus reducing investment in American enterprises. These displacement effects occur whether M>X (the usual condition for the U.S.) or M>X (the usual condition for the U.S.). In the first instance, L reduces or negates the benefits of the trade deficit, namely, a net gain in the goods available to American consumers and a net inflow of funds to American enterprises.

Cases 2 and 3 underscore an essential point: L is just a substitute for T when it comes to the diversion of resources from private uses to government uses, and it matters not whether the lenders are foreign or domestic. But the effect of $Ga on GDP does depend on the distribution of $Ga between T and L and their precise terms (e.g., the progressivity of income-tax rates).

The foregoing discussion leads to the following general model:

(9) GDP = δC′ + ηI- G

GDP = GDP with international trade and government;
δ= 1 – the fraction by which C is reduced by Ga;
η = 1 – the fraction of by which I is reduced by Ga; and, as discussed above,
G = the portion of government spending that represents resources actually depleted in governmental uses.

In words: The usual case is that Ga diminishes GDP, resulting in GDP < GDP′.

The effects symbolized in (9) are not easily disentangled. In fact, it probably is impossible to disentangle them. The best that one can do is to express them in a general way. I begin with this:

(10) γ = f(Ga, $Ga)

γ measures the combined effects of Ga and $Ga;
γ ≥ 1 when (7) is satisfied; otherwise,
γ < 1.

Therefore, GDP in an economy with government:

(11) GDP = γGDP


The usual case, for more than 120 years, has been γ < 1 and, therefore, GDP < GDP.

To show this, I begin with a simple model of economic growth:

(12) GDPb + n = GDPb(1 + ρ)n

b and n, as subscripts or superscripts, denote the base year and/or the number of years after the base year;
ρ = annual rate of real growth when γ = 1; and
ρ incorporates the direct and recombinant effects of innovations that boost the rate of growth, given any rate of saving and any stock of labor and capital. (See the Wikipedia article, “Neoclassical growth model,” and Martin L. Weitzman, “Recombinant Growth,” Quarterly Journal of Economics, May 1998.)

Then, in the case where γ takes a constant value other than 1 in every year after b:

(13) GDPb + n = GDPb(1 + ρ*γ)n

To illustrate the cumulative effect of γ < 1, I use estimates of real GDP (in constant, 2005 dollars) derived from the feature “What Was the U.S. GDP Then?” at Measuring And I take 1890 as the base year. The effects of the early legislative “accomplishments” of the Progressive Era – the establishment of the Interstate Commerce Commission in 1887 and the passage of the Sherman Antitrust Act in 1890 – began to weigh on the economy after 1890. (I have elsewhere used 1907 as a base year, but the choice of any year during the Progressive Era will lead to the same conclusion, namely, that the heavy hand of government put an end to the economic dynamism that followed the Civil War.)

Real GDP was $319 billion in 1890; it had risen to $13.3 trillion in 2011 — a compound growth rate of about 3.1 percent. But real GDP in 2011 would have been more than $104 trillion had growth continued at an annual rate of 4.9 percent after 1890 (the rate of growth from 866 through 1890). Instead, the combined effect of Ga and $Ga after 1890 was the same as if γ had been 0.639 in every year from 1891 through 2011:

(14) GDP1890 + 121  = GDP2011(1 + 0.049*0.639)121 =$0.319(1.0313)121=$13.3 (in trillions)

It is little wonder that real GDP in 2011 was only one-eighth of what it would have been had the economy not been stifled by the expansion of Ga and $Ga.(especially after 1929). What happened? The heavy hand of government (at all levels) made itself felt by discouraging work, discouraging the saving that makes investment possible, discouraging innovation, and (even to the extent that innovation persists) discouraging the investments required to bring innovation on line. How? It begins with the diversion of resources to governmental activities, and is compounded by the cumulative disincentivizing effects of taxes, regulations, administrative procedures, statutes, ordinances, executive orders, and judicial decrees.

The value of γ for a particular year, given $Ga/GDP for that year, can be derived from the equation for the Rahn curve. That equation, which I derive in “Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth,” is as follows:

(15) ρr = -0.066($Ga/GDP) + 0.054

where ρr represents the value of ρ as a function of $Ga/GDP.

The constant term is greater than my estimate of ρ = 0.049 (baseline rate of growth with minimal government) because the equation is linear; it does not “bend” at the point where is $Ga/GDP at an optimum (probably between 0.04 and 0.08).

If $Ga/GDP = 0.4 (where it has hovered for the past few years), then by (15) ρr = 0.028 (2.8 percent). Therefore, if ρ (baseline rate of growth with minimal government) = 0.049, then γ (for $Ga/GDP = 0.4) = 0.57. That is to say, government activities and spending are now reducing the rate of growth by more than 40 percent from its potential value.

As it turns out, the actual year-over-year rate of growth in real GDP has ranged from 1.6 percent to 2.8 percent since the end of 2009. My history-based point estimate of 2.8 percent is on the high side. Why? Because the economy is suffering from a worse-than-usual case of regime uncertainty. (See, for example, “Regime Uncertainty and the Great Recession,” “Economic Growth Since World War II,”and “The Obama Effect: Disguised Unemployment.”)

Defenders of big government will say that the rate of growth could not have been sustained at something like 5 percent. But such an assertion, if it is based on anything other than ignorance, is based on a simple, sub-exponential model of growth, where returns on investment are diminishing. This model overlooks the effects of innovation and recombination, mentioned in connection with equation (12). If the model of ever-diminishing growth were correct, the U.S. economy would not have experienced rising growth in the first 20 to 25 years after the end of World War II. (See the first graph in “Economic Growth Since World War II.”) No, the defenders of sub-exponential growth must look to the Great Society — and to the continuous expansion of the administrative state — if they wish to understand the artificially low rate at which the economy is growing.


A. The Religion of Big Government

Despite what I have said here about the deleterious effects of Ga and $Ga – especially where $Ga is larger than required to defend the lives, property, and liberty of Americans – there are true believers who maintain that the greater the scope of Ga and the larger $Ga is, the better and richer America will be.

The believers in the engrossment of Ga and $Ga evidently have not considered their cumulative effects on the incomes and wealth of Americans. As the preceding analysis suggests, those relatively few Americans who would not be better off with γ ≥ 1would be the beneficiaries of a pool of charitable giving that is vastly greater than the present pool. (This would be true even if such things as Social Security, Medicare, Medicaid, food stamps, and extended unemployment benefits were counted as “giving,” even though they are financed by “taking.”)

I suspect, however, that many of the proponents of big Ga and $Ga simply refuse to consider their deleterious effects because the proponents are fixated on the idea of wealth as an evil thing — when it is held by others, of course. (See “Taxing the Rich” and “More about Taxing the Rich.”) That fixation may be sincere, in some cases, but in its more virulent form it is a political stance, adopted to gain power for the purpose of aggrandizing government. That big government might be harmful, even to the “little people” who are its supposed beneficiaries, is of no account to its worshipers – as long as they run it, advise in the running of it, profit by it, or simply enjoy watching it run roughshod over the lives and fortunes of others. Power and the vicarious enjoyment of power are habit-forming drugs.

The anti-wealth stance of the left — hypocritical as it is when it emanates (as it often does) from highly paid academics, well-connected politicians, cosseted bureaucrats, and a sparkling array of super-rich entertainers, celebrities, and “moguls” – is of a piece with other leftist emanations of Puritanism: anti-smoking, anti-obesity, anti-censoriousness (toward the left’s pets, such as Islam, gays, and selected “minorities”). The left’s proclaimed sympathy for the “little guy” is about as valid a counterfeit bank note, when the “little guy” is a job-holding, beer-drinking, fast-food eating, overweight, married-with-children, possibly church-going, white, wage-laborer. Given that the rich and famous are often heard to declaim against “privileges” of the economic class to which they belong, one must suppose that their hypocrisy has two sources: economic ignorance, which leads them to believe that they are the beneficiaries of a zero-sum game, and guilt about the “fact” that their winnings come at the expense of others. I have noticed that their guilt, though it may lead them to contribute to charity, also leads them to press for higher taxes on their ilk. It is as if higher taxes (which benefit already well-paid politicians and bureaucrats) were somehow better than charity, which can be made to flow directly to its intended beneficiaries. The call for higher taxes is an admission of guilt, not a sign of compassion. Were wealthy leftists truly compassionate about the plight of the unfortunate, they would disclaim their worldly goods and live among the unfortunate. But, instead, they live among their ilk and live truly well. If only they would not feel guilty about it.

As mentioned above, academics are complicit in the veneration of big government. The next sections address two major rationalizations of big government — the Keynesian fallacy and the myth that government is the same as community — both of which are perpetuated by “intellectuals.” That myth was celebrated in a video produced for the Democrats’ national convention in 2012. The title of the video: Government Is the Only Thing We All Belong To. (Related reading: “‘Intellectuals and Society’: A Review” and “‘Big SIS’: A Review.”)

B. The Keynesian Fallacy

From the onset of the financial crisis that led to the Great Recession, and through the Great Recession unto the present day, prominent voices have urged massive government spending as the solution to what is nothing less than a government-created problem. (See Arnold Kling’s, Not What They Had in Mind, for a thorough analysis of the causes of the financial crisis.)

I have written many posts about the counterproductive effects of government action and the failure of the “stimulus” to stimulate the economy. (See the list of related posts at the bottom of this post.) The following discussion is adapted from one of them, “A Keynesian Fantasy Land.”

Altogether, there are six reasons for the ineffectiveness of Keynesian “stimulus.”

1. The “leakage” to imports

…In Keynesian parlance there is the multiplier effect and it is greater than 1. As long as there is spare capacity (unemployment) in the economy, the government ought to go on spending more, working through the multiplier, because the extra private saving takes care of the government dissaving and the extra consumption is, so to speak, a welcome windfall gain. Timidly refusing to generate it is criminal waste.

Despite truculent voices to the contrary, the Keynesian logic is faultless in that the conclusions do follow from the assumptions. Why it does not really work and why it singularly failed to work in 2009-2010 and maybe beyond, is that other things do not remain equal. Part of the extra spending stimulus fails to stimulate domestic income because as much as 0.3 of the multiplier might leak out through extra imports. Much of the rest may be offset by industry taking fright of the rising budget deficit and reducing investment, and consumers striving to reduce their indebtedness producing some saving to balance the government’s dissaving. The total effect of higher imports and lower investment might be a multiplier barely higher, or maybe even lower, than 1 and the stimulus stimulating nothing except the national debt. This is not the fault of Keynes but of those whose macro-economics exist in a fantasy land. (Anthony de Jasay, “Micro, Macro, and Fantasy Economics,” Library of Economics and Liberty, December 6, 2010)


[t]he available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. (Robert J. Barro and Charles J. Redlick, “Stimulus Spending Doesn’t Work,” WSJ Online, October 1, 2009)

(For more on the subject see Barro’s “Government Spending Is No Free Lunch,” WSJ Online, January 22, 2009.)

2. The disincentivizing effects of government borrowing and spending

As de Jasay suggests, industry (and the high-income earners who finance it) are being cautious about the implications of additional government debt. As I say here,

the sophisticat[ed] … institutions and persons who have the greatest interest in government’s actions [are] large corporations and persons in high-income brackets. They will react to government borrowing as if it would affect them and their heirs (corporate and individual).

That is to say, even if additional debt does not crowd out private-sector borrowing to finance business expansion, it will nevertheless inhibit investments in business expansion. This inhibiting effect is compounded by the reasonable expectation that many items in a “stimulus” package will become permanent fixtures in the government’s budget.

3. The timing-targeting problem

The lag between the initial agitation for “stimulus” and its realization. In the extreme, the lag can be so great as to have no effect other than to divert employed resources from private to government uses. But even where there is a relatively brief lag, “stimulus” spending is essentially wasted if the result is simply to divert already employed resources from private to government uses.

The timing-targeting problem is one that strident Keynesians and their unsophisticated disciples in the media seem not to understand or care about. (They are happy as long as government “does something,” regardless of the cost.) The problem arises from the fundamental flaw in the Keynesian analysis: Economic output is portrayed as a homogeneous commodity, one that can be characterized  in terms of aggregate demand (AD) and aggregate supply (AS). Accordingly, in the Keynesian orthodoxy, all it takes to stimulate AD is to pump in some additional government spending (dG), and the rest takes care of itself.

Arnold Kling calls it “hydraulic” macroeconomics:

Once upon a time, Joe lived in Keynesiana, where he was a representative agent.

Joe worked in a GDP factory, making GDP. Every Monday morning, he went to work, and he worked five days a week. He was paid $1 for every 24-minute segment he worked, and he worked 100 segments (40 hours), so he earned $100 a week. Every Friday afternoon, Joe cashed his paycheck and went to the GDP factory outlet, where he spent it all on GDP.

One day, Joe decided that he needed to accumulate some savings. He made up a rule for himself. Knowing that he needed to consume at least $40 of GDP each week, he decided that his rule would be to save 20 percent of everything he earned over and above that $40. So the first week, that meant saving 20 percent of $60, or $12. So he cashed his $100 paycheck, but that Friday afternoon he only spent $88.

Next Monday, morning, Joe’s boss had some news. “A funny thing happened last week. We sold 12 percent less GDP than usual. So this week, we’re gonna put you on a short week. You work 88 segments, instead of 100.”

Joe was disappointed, because this meant he would only be paid $88 this week. Sticking to his new rule, he resolved to save 20 percent of $48, or $9.60. So that Friday afternoon, he cashed his $88 paycheck and spent $78.40.

Next Monday morning, Joe’s boss said. “Well, golly, it looks like we sold even less GDP last week. I’m afraid we’ll have to cut you back to 78.40 segments this week.” Still following his rule, Joe resolved to save 20 percent of $38.40, or $7.68. So he spent only $70.72 at the GDP factory outlet that Friday.

Seeing where this was going, the country asked Krug Paulman, the famous economist, what to do. He said, “The stupid people are saving too much. We need government to spend what the idiots are not spending.” So the government borrowed $29.28 from Joe and spent it at the GDP factory outlet.

Now, when Joe came to work on Monday morning, his boss said, “Good news, we sold 100 percent of what we used to sell, so you can work 100 segments this week.” Sticking to his rule, Joe saved $12 on Friday afternoon. But the government borrowed the $12 and spent it at the GDP factory outlet. They all lived happily ever after. (Library of Economics and Liberty, “Hydraulic Macro: A Fable,” August 30, 2009)

But in reality, economic activity is far more complex than that. One very important part of that reality the vast variety of goods and services changing hands, in response to constantly shifting tastes, preferences, technologies, and costs. The real economy bears no resemblance to the “hydraulic” one in which the homogeneous “fluid” is units of GDP. For “stimulus” — an increase in government spending (dG) — to generate an real increase GDP significantly greater than dG, several stringent conditions must be met:

(1) dG must lead directly to the employment of resources that had been idled by a downturn in economic activity (or newly available resources that otherwise would lay idle), therefore eliciting the production of additional goods for delivery to consumers and businesses.

(2) Accordingly, government functionaries must be able to distinguish between unemployment that occurs as a result of normal (and continuous) structural changes in the economy and unemployment that occurs because of a general slowdown in economic activity.

(3) To the extent that the preceding conditions are satisfied, dG may be used to restore employment if government functionaries do the following things:

  • Ensure that dG is used to purchase goods and services that would have been produced in the absence of a general slowdown in economic activity.
  • Ensure that dG is used by those persons, businesses, and governmental units that have become unable to buy those goods and services because of a general slowdown in economic activity.
  • Allowing for shifts in tastes, preferences, technologies, etc., adjust the issuance, allocation, and use of dG so that goods and services are produced in accordance with those shifts in taste, etc.
  • Reduce dG as the demand for unemployed resources rises, in order to avoid the distorting and disincentivizing effects of inflation.

To the extent that dG is less than on-time and on-target, there is “leakage,” which causes the multiplier to recede toward a value of 1. It can easily slide below 1 — as Barro has found — because of the “leakage” to imports and the disincentivizing effects of government borrowing and spending.

4. Causality: Inadequate Aggregate Demand (AD) as symptom, not cause

The fourth reason for the failure of the “stimulus” to stimulate is that it is does not address the cause of the drop in AD. A drop in AD usually is caused by an exogenous event, and that exogenous event usually is a credit crisis. Pumping money into the economy — especially when it results in the bidding up the prices of already employed resources — does not reinflate the punctured credit bubble that caused the slowdown.

If a credit crunch arises from a sharp rise in the rate of home-mortgage defaults — as in the case of the Great Recession — the obvious way to “solve” the problem is to prop up the defaulting borrowers and their lenders, and to do so quickly.

But, in practice, the propping up is hit-and-miss, and the misses have drastic consequences. Consider, for example, the decision not to bail out Lehman Brothers and the effects of that decision on financial markets.

Which leads into the fifth reason…

5. Inequity, moral hazard, and their consequences

Any kind of “stimulus” that targets particular individuals and firms, in an effort to rectify their failures of judgment, has adverse political and economic effects.

Favorable treatment of defaulters and failing companies generates considerable popular resentment, which — in the present instance — has found a vocal and politically potent outlet in the Tea Party movement. Favorable treatment of defaulters and failing companies also creates moral hazard; that is, it encourage unwise risk-taking that can (and probably will) spark future crises, leading the government to assume more obligations and impose more regulations, in a futile effort to change human nature.

All of this adds up to a climate of political contention and financial pessimism — conditions that militate against consumer confidence and business expansion.

6. The human factor

The preceding five reasons for the ineffectiveness of Keynesian “stimulus” point to a sixth, fundamental reason: the human factor.

Models are supposed to mirror reality, not the other way around. Those who cling to the Keynesian multiplier would like the world to comply with it. But the world does not because it is filled with people, whose behavior is not determined (or described) by a simplistic model but by their responses to incentives, their political predispositions, their informed and reasonable skepticism about the consequences of government intervention in economic matters, and — above all else — their fallibility. And, believe or not, government officials and bureaucrats are no less fallible than the “ordinary” citizens whose lives they would like to organize.

The human factor is an inconvenient truth. But “liberals,” in their usual arrogance and ignorance prefer magical thinking to reality. Belief in the Keynesian multiplier is a prime example of magical thinking.

C. Government as Community, or “We Owe It to Ourselves”

“We owe it to ourselves” is a phrase used by Paul Krugman (among others on the left). It is a variant of the stock rationale for socializing gains and losses: “We’re all in this together.” As if the citizens of the United States were members of an extraordinarily large community, with a perpetual town-hall meeting conducted by the government of the United States.

Consider the intellectual dishonesty of Krugman’s claim that “we” owe the debt of the U.S. government to “ourselves.” My response:

Who are “we”? If government borrows money and spends it on goodies for Congressman X, Y, and Z’s districts, how do I get my cut? Or does the happiness generated in Congressman X, Y, and Z’s districts simply radiate in waves across the country, eventually reaching me and making me feel better?

If the borrowed money makes (some) people in Congressman X, Y, and Z’s districts better off, why is it that “we” (i.e. the rest of us and/or our descendants) end up repaying the debt that made those others better off? I do not understand how I “owe it to myself” when (a) I didn’t ask to borrow the money and (b) I gained nothing as a result of the borrowing.

You might claim that my personal wishes are of no account because Congress and the president are duly elected by majorities of voters. But that is tantamount to saying that Congress and the president possess a kind of omniscient super-consciousness that somehow overrides the harm, hate, and discontent that flow from their acts.

Leftists talk and act as if there were such a thing as a social-welfare function; that is, they (in their unerring wisdom) know how much should be taken from A and given to B in order, somehow, to make all of “us” better off. But all that happens when money is taken from A and given to B is that A is worse off and B is better off (though probably not in the long run if he becomes dependent instead of self-reliant).

The view of government as mysteriously attuned to a (fictional) collective consciousness – “the will of the people” – is so pervasive that I can only bring myself to cite one other example. It is much like the Krugman case, but far more subtle.

A paper whose lead author is James K. Galbraith — another academic and the genetic and intellectual offspring of John Kenneth Galbraith — makes a case against intergenerational accounting. Now, I am not sanguine about intergenerational accounting; its core (unstated) assumption is that there is such a thing as a social-welfare function. But Galbraith and his co-authors are not about to challenge that assumption. Their complaint about intergenerational accounting is that it is being used to attack the idea of social welfare, as embodied in Social Security and Medicare.


[T]he government’s interest is the public interest. The government is there to provide for the general welfare….

In the real world, we observe that the U.S. federal government tends to run persistent deficits. This is matched by a persistent tendency of the nongovernment sector to save. The nongovernment sector accumulates net claims on the government; the nongovernment sector’s “net saving” is equal (by identity) to the U.S. government’s deficits. At the same time, the nongovernment sector’s net accumulation of financial assets (or “net financial wealth”) equals, exactly, the government’s total net issue of debt—from the inception of the nation. Debt issued between private parties cancels out; but that between the government and the private sector remains, with the private sector’s net financial wealth consisting of the government’s net debt. (Galbraith et al., “The Case Against Intergenerational Accounting: The Accounting Campaign Against Social Security and Medicare,” The Levy Economics Institute of Bard College, Public Policy Brief, No. 98, 2009, pp. 7,9)

There is no such thing as the general welfare. And anyone who knows more than a little about government – as Galbraith does – is aware that, in the main, government is a poaching-ground for special interests. (See, for example, “Enough of ‘Social Welfare’,” “Merit Goods, Positive Rights, and Cosmic Justice,” and “The Capitalist Paradox Meets the Interest-Group Paradox.”)

Galbraith and company compound their (feigned) ignorance of reality by treating the private sector as a “party,” when it is millions of parties, some of whom are enriched at the expense of others when government borrows to provide for “the general welfare.” Then there is the ridiculous notion that “saving” in the form of government debt — which is incurred for purposes that diminish economic growth — is as good as real saving, which enables private-sector investments that foster economic growth.

The left succeeds, in large part, because apologists for big government — from Krugman and Galbraith to Clinton and Obama — are skillful practitioners of slippery logic. An assumption here, an assumption there, and the next thing you know government spending is a source of enrichment. The hard truth is that government spending — and the big government that it supports — is the source of America’s impending impoverishment.

Related posts:
Trade Deficit Hysteria
Trade, Government Spending, and Economic Growth
The Causes of Economic Growth
In the Long Run We Are All Poorer
A Short Course in Economics
Addendum to a Short Course in Economics
The Price of Government
Gains from Trade
The Price of Government Redux
The Indivisibility of Economic and Social Liberty
The Mega-Depression
As Goes Greece
Ricardian Equivalence Reconsidered
The Real Burden of Government
Toward a Risk-Free Economy
Enough of “Social Welfare”
Subjective Value: A Proof by Example
Microeconomics and Macroeconomics
The Illusion of Prosperity and Stability
Society and the State
I Want My Country Back
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
Our Enemy, the State
“Intellectuals and Society”: A Review
Subjective Value: A Proof by Example
The Stagnation Thesis
Taxing the Rich
More about Taxing the Rich
Does World War II “Prove” Keynesianism?
Money, Credit, and Economic Fluctuations
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Creative Destruction, Reification, and Social Welfare
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
The Real Multiplier
Vulgar Keynesianism and Capitalism
Why Are Interest Rates So Low?
Merit Goods, Positive Rights, and Cosmic Justice
The Commandeered Economy
We Owe It to Ourselves
Estimating the Rahn Curve: A Sequel
The Real Multiplier (II)
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
More Evidence for the Rahn Curve
“Big SIS”: A Review
The Capitalist Paradox Meets the Interest-Group Paradox
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The Obama Effect: Disguised Unemployment