The economic logic of fiscal stimulus is a straightforward application of the basic Keynesian macroeconomic theory.  Labor and other resources can be unemployed because private businesses do not expect to sell enough to justify the full use of these resources.  To solve this critical social problem, demand must increase.  When private spending does not do what is necessary, the government can step in to stimulate demand and thereby raise both employment and production.

Have you read the Keynesian Basics pages?  They don’t take too long.  Click here for an overview of the background ideas that will help to clarify the discussion of fiscal policy here.

For example, consider the dilemma confronting the U.S. economy in the aftermath of the Great Recession that began in late 2007.  American consumption spending had created robust demand growth for decades, but that spending was financed to a large degree by unprecedented, and ultimately unsustainable, household borrowing.  When financial turmoil in housing and other markets cut Americans off from further borrowing, they had to reduce their spending by a huge amount.  Private demand collapsed, pulling production and employment down with it. 

One response to this dilemma is to replace, at least partially, the private demand loss with demand supported by the government.  Higher government spending raises demand directly when it expands government projects and programs.  Government spending can also boost demand indirectly, through tax cuts or higher transfer payments that raise demand when they land in the pockets of households or firms that spend them.  

The logic of this policy response is simple, but it faces stiff resistance, in particular because higher government spending, without higher taxes, increases the amount that the government borrows.  Critics draw often misleading analogies between personal debt and government borrowing.  They fear that government borrowing is “irresponsible” and fret about the perils of a supposedly “unsustainable” amount of debt and associated interest costs that they argue must be borne by future taxpayers.  This rhetoric can get moralistic, along the lines that it is somehow “wrong to spend money that we do not have,” again with the justification being an often implicit assertion that government finances are just like those of a private household.  Indeed, we often hear politicians invoke logic along the lines of U.S. Representative Jim Jordan’s statement:  “It’s simple. Spend what you take in. That’s what every family has to do … imagine the federal government actually doing what makes sense” (quoted in a blog by Richard Cowan on May 16, 2011, “Families may not be the model for debt limit fix.”)

This anti-deficit rhetoric may stem from a sincere desire to “do the right thing” because deficit hawks genuinely believe that debt is damaging (or even immoral).  Politicians and pundits reinforce what people already are prone to believe.  The result is austerity fever, illustrated in political campaigns and legislative disputes.

According to the MWM perspective, however, these messages mislead the public about the true costs of government deficits and distract attention away from how government actions can create the demand necessary to mobilize unemployed resources, creating both new jobs and higher incomes.  The paragraphs below examine the most common deficit fears and demonstrate that worries about deficits and debt are often exaggerated in public discourse, with the result that the policy toolbox available to fight unemployment and economic stagnation may be needlessly constrained.

Debt vs. Deficit
What is the difference between government debt and a government deficit?  The deficit is the gap between spending and tax revenue over some period (usually a year), while debt is the accumulated shortfall that gets carried over from year to year.  Therefore, the debt is the sum of all budget deficits less the sum of (rare) surpluses in U.S. history.  In economists’ jargon, the deficit is a “flow” as it is measured over a period of time, while the debt is a “stock” measured at a point in time.  A simple metaphor clarifies the concept.  Think of the debt as the stock of water in a bathtub.  The deficit is the flow of water that is added to the tub over a particular period.

Where Does the Money Come From?

Among the most common criticisms of fiscal stimulus is that the rise in demand cannot create a net benefit for the economy because the stimulus money must come from somewhere.  This view implies that the effect of demand stimulus is neutralized by contraction of some other activity from which the stimulus money was taken.  Politicians and pundits often reflect this thinking with statements along the lines of “we can’t spend money that we don’t have.”

The underlying, and incorrect, assumption behind this way of thinking is that the amount of “money” (in the sense of income) available to the economy as a whole is fixed independently of the amount of spending.  This confusion is understandable, because it is natural for people to try to understand the effects of government spending and debt by drawing a familiar analogy to their personal financial situation.  For an individual household, income is independent of the household’s own spending.  But that is not the case for the system as a whole:  national spending and national income cannot be independent of one another under most circumstances.

Government Spending at Full Employment.
If government spending rises when resources, particularly labor, are fully employed, then that policy will necessarily reduce some other activity in the economy.  For example, during World War 2, the huge demand for military production reduced production of goods and services for private use.  This “crowding out” of private spending was explicit during the war years through rationing of the amount of many commodities private citizens could purchase.  But full employment is not the typical state of the U.S. economy, especially in recent years.  This issue is discussed more fully on the crowding out page of this fiscal policy section.

Let’s examine this argument in more detail.  Consider what happens when the government increases its spending on computers from a private computer manufacturer. The government’s spending raises the computer company’s revenues.  These revenues become wages for company employees and profits for its owners.  Would these incomes exist without the government stimulus?  The answer depends on the extent of under-employed resources in the economy.  If the computer company is like most businesses, it has some excess capacity and it will be anxious to fill the new government orders with new production that brings additional capacity into use.  And when it expands, there is a good chance that it will hire additional workers, reducing unemployment.  This is the basic logic of Keynesian macroeconomics:  higher demand mobilizes otherwise idle resources (particularly labor), creating new incomes that would not exist without the higher level of government spending.

Thus money to finance increased government stimulus need not come out of incomes that existed prior to the rise in government spending; demand stimulus itself creates income so there is more money to go around in the economy as a whole after the rise in spending.

While this result explains how higher spending by the government eventually creates new incomes, careful readers may wonder where the initial demand stimulus comes from.  Doesn’t the government’s original spending still have to come from someone else’s pocket?  The answer is somewhat subtle.  As a practical matter, the federal government spends by writing a check on its account with the Federal Reserve.  The Fed can literally create the money necessary to cover these checks.  The U.S. Treasury does not have to deposit revenues from taxes or borrowed money in its Fed account before spending.  In this important sense, the initial spending, which usually creates new incomes as described above, does not have to take money from any private sector household or firm.

Modern Monetary Theory
The ability of the government to spend without first imposing taxes or borrowing from the private sector is discussed in detail by economists who subscribe to what has become known as “modern monetary theory.”  Interested readers can find more about these ideas here.

The government may choose to raise taxes to cover its higher spending.  In this case, the effect on demand is a combination of the direct increase in government spending and the indirect reduction in private spending caused by higher taxes.  In most cases, however, fiscal stimulus leads to more borrowing from the private sector.  In this case, the government deficit rises.  Borrowing does not reduce private demand directly because the money borrowed by the government is money saved, not money spent, by the private sector.   This is the reason that Keynesian theory predicts greater demand stimulus from deficit-financed government spending than from tax-financed spending:  higher borrowing does not reduce private demand while higher taxes will, most likely, reduce private spending.

Do Government Deficits Reduce Private Spending?
If the government borrows instead of taxes it does not directly reduce private demand because it is taking money saved by the private sector.  But economists have identified a possible indirect effect of higher government deficits on private spending.  Suppose that households anticipate that higher government deficits today will lead to higher future taxes to pay the interest, and possibly the principal, of the new government debt.  Then households could choose to reduce today’s spending, to save for higher expected taxes in the future.  Economists label this effect “Ricardian equivalence” after the famous 19th century economist David Ricardo who introduced this way of thinking to economic discourse.  We discuss this issue and its impact on modern fiscal policy debates here.

Regardless of whether higher government spending is associated with more money created by the central bank, higher taxes, or more borrowing, higher government spending raises demand and creates incomes, as discussed with the computer company example above.  The government does not have to take money from the private sector.  Instead, government spending increases the “money,” that is, the income, of the private sector when it mobilizes under-utilized resources and labor.  If the government raises its deficit when it spends more, we need to consider the indirect effects induced by the deficit, such as possibly higher interest rates.  We discuss this issue on the crowding out page.  But we must recognize how government spending, just like private spending, provides economic stimulus through its effect on demand.

More From the Critics

In an op-ed entitled “Why Americans Hate Economics” (August 19, 2011 Wall Street Journal, page A11), Stephen Moore writes:  “for the government to spend a dollar it has to take it from the private economy that is then supposed to create jobs.  [This] theory only works if you believe there’s a fairy passing out free dollars.”  The analysis here shows that “fairies” are not required.  When the government, or any other entity in the economy, spends, that spending creates new income through the employment of previously idle resources.  Thus, the “money” (in the sense of income) need not be taken from the “private economy,” in fact higher government spending can raise the amount of income and money circulating in the private sector.  Click here for further discussion of this kind of criticism; in particular we address the idea that the Keynesian theory of fiscal stimulus somehow implies that the government creates a “free lunch” that violates the basic laws of economics.

Key Points

  • Government spending adds to demand just like private spending.  If resources are under-utilized, this new demand encourages firms to produce more and hire more workers.
  • Production and jobs that result from government spending create new incomes.  Therefore, rather than taking away income and money from the private sector, government stimulus can add to the money flowing through the private economy.