The battle between the Keynesians and the supply-siders has returned with a vengeance. The economic situation is not in dispute: an already slumping economy took a big hit on September 11. Billions of dollars of wealth vanished in just a few hours. Numerous companies have announced layoffs, with total job losses in the hundreds of thousands. Previously flat economic growth will undoubtedly slip into recession.
Many have asked what kind of economic policy the government should undertake to help out. To these people, I would first point out that this question rests on a false premise: the idea that the government should engage in economic policy at all. But surely, we can at least examine the proposals and see what is reasonable and what is nonsensical. (In all fairness, neither side speaks with one voice, but there are some definite trends and common ideas.)
The Keynesians suggest that our economy’s basic problem is lack of demand; therefore, they urge increased government spending on infrastructure, be it roads or schools or reconstruction of damaged areas, another tax rebate (this time targeted largely to the poor), higher unemployment benefits (for the poor), and cuts in payroll taxes, which affect mostly the poor and middle-class. The essential things the government needs to do, according to Keynesian economists, are borrow money and spend it. Whatever we do, they demand, we must not reduce taxes on the rich, who already got a tax cut earlier this year; the rich won’t spend that money anyhow.
The supply-siders see a different problem: a recession caused by slumping business investment. Therefore, they suggest, we must boost the incentives to save and invest. They want to allow businesses to expense their investments more quickly, accelerate the previously enacted tax rate cuts, repeal the corporate alternative minimum tax (which hits especially hard during recessions), and reduce capital gains taxes. These actions will increase the amount of capital available for investment and the rates of return on investments.
The Keynesians’ ideas about spending rely on a concept known as the “multiplier.” If you give someone $100, they’ll spend some fraction of it; say they spend $80 and save $20. Then the person who receives the $80 will in turn spend $64, and so on. The total spending that results from this $100 gift is, in fact, $400. In this case, the multiplier is four; its actual value depends on the economic variable known as the marginal propensity to consume: the fraction of the gift spent each time.
By this theory, to boost consumption, and thus the economy, the government should spend more and give money to the poor and middle class. Keynesians point to a fact not in dispute, that the marginal propensity to consume drops with income, and conclude that government spending is beneficial.
This analysis fails on several levels. It completely ignores where the money came from. Governments obtain money in three ways: taxing, printing, and borrowing. Taxes take money from one person and give it to another. There may be a small effect if the person taxed is richer than the person receiving the transfer payment, but the multiplier is essentially wiped out. In the second case, printing money merely causes inflation, and is equivalent to a wealth tax, so the analysis is the same. Finally, borrowing not only involves a cash transfer and falls through by the same analysis, but creates an additional government debt to be paid by taxation. Printing money to pay off a debt is a certain recipe for hyperinflation.
Now, even if this policy did boost consumption, it would not create wealth. Goods must be produced before they can be consumed. What is produced but not consumed is called savings; when consumption exceeds production, savings are depleted. The problem is that wealth is being measured in terms of money, not in terms of goods. Imagine that everyone suddenly had twice as much money. Businesses would double their prices, and nothing would have changed. Money alone is not a measure of wealth; money is only valuable because it can buy things. Giving people more money to consume will not increase purchasing power; it will merely increase prices.
The mindlessness of deficit spending is best illustrated by a classic example: the government that pays people to dig ditches and fill them back up. This gets money moving around in the economy, but obviously, it creates no wealth; in fact, it wastes productive energy. A real-world example is Japan’s experience in the 1990s. Japan didn’t exactly dig ditches and fill them back up, but it did go on an orgy of deficit spending for public works projects, and has nothing to show for it but a recession and a massive national debt.
Once we recognize that consumption cannot create wealth, the rest falls into place easily. If a government wishes to promote the creation of wealth, it must promote production, not consumption. Production can only be increased in three ways: more labor, more capital, and better technology.
Labor is largely fixed in any industrialized economy with low population growth, but capital and technology can grow without limit. Capital is investment; investment is savings; and savings is past production that was not consumed. To increase the capital stock, we must therefore encourage investment. Technology is also linked to capital and investment. It is only through investment in research that technology will ever improve.
So, insofar as the creation of wealth goes, the supply-siders are invariably in the right. Wealth is production, and production requires investment. The supply-siders don’t have a short-term fix for the current situation, true. But theirs is the only solution that can work, because they recognize in the words of one of the great presidents of the 20th century, an ardent supply-sider, that “If we look to the answer as to why for so many years we achieved so much, prospered as no other people on Earth, it was because here in this land we unleashed the energy and individual genius of man to a greater extent than has ever been done before.”