The Myth of Spending as “Stimulus”

Spending-stimulus advocates claim that government can “inject” new money into the economy, increasing demand and therefore production. This raises the obvious question: Where does the government acquire the money it pumps into the economy?

Congress does not have a vault of money waiting to be distributed: Therefore, every dollar Congress “injects” into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another.

Spending-stimulus advocates typically respond that redistributing money from “savers” to “spenders” will lead to additional spending. That assumes that savers store their savings in their mattresses or elsewhere outside the economy.

In reality, nearly all Americans either invest their savings by purchasing financial assets such as stocks and bonds (which finances business investment), or by purchasing non-financial assets such as real estate and collectibles, or they deposit it in banks (which quickly lend it to others to spend). The money is used regardless of whether people spend or save.

Government cannot create new purchasing power out of thin air. If Congress funds new spending
with taxes, it is simply redistributing existing income. If Congress instead borrows the money from domestic investors
those investors will have that much less to invest or to spend in the private economy. If Congress borrows the money from foreigners, the balance of payments will adjust by equally reducing net exports, leaving GDP unchanged. Every dollar Congress spends must first come from somewhere else.

This does not mean that government spending has no economic impact at all. Government spending often alters the composition of total demand, such as increasing consumption at the expense of investment.

More importantly, government spending can alter future economic growth. Economic growth results from producing more goods and services (not from redistributing existing income), and that  requires productivity growth and growth in the labor supply. A government’s impact on economic growth is, therefore, determined by its policies’ effect on labor productivity and labor supply.

Productivity growth requires increasing the amount of capital, either material or human, relative to the amount of labor employed. Productivity growth is facilitated by smoothly functioning markets indicating accurate price signals to which buyers and sellers, firms and workers can respond in flexible markets. Only in the rare instances where the private sector fails to provide these inputs in adequate amounts is government spending necessary. 

For instance, government spending on education, job training, physical infrastructure, and research and development can increase long-term productivity rates - but only if government spending does not crowd out similar private spending, and only if government spends the money
more competently than businesses, nonprofit organizations, and private citizens.

More specifically, government must secure a higher long-term return on its investment than taxpayers’ (or investors lending the government) requirements with the same funds. Historically, governments have rarely outperformed the private sector in generating productivity growth. In fact, most government spending has historically reduced productivity and long-term economic growth.

Why Government Spending Does Not Stimulate Economic Growth by Brian M. Riedl, Senior Fellow, The Heritage Foundation