Why Economic Growth Cannot be ‘Stimulated’ by Recirculating Money

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Well, we heard it again! This time from Cenk Uygur:

“When taxes are higher it winds up being better for the economy … because it recirculates the money.”

This is a variant of Keynesian multiplier argument that when government spends a dollar, it generates more than a dollar’s worth of economic activity, which leads to economic growth.

What the Keynesians don’t seem to understand is that circulation of money in itself does not create economic value. Lack of value creation leads to zero economic growth, which in turn leads to increased poverty and inequality. Keynesian stimulus leads to creation of dangerous economic bubbles like the housing bubble.

“You pay a guy to dig a hole and pay another guy to fill the hole. Isn’t that how the economy works?”

Jon Stewart asked that question several times on his TV show, exemplifying Keynesian thinking which is similar to the broken window fallacy. The short answer is ‘no,’ that‘s not how the economy works.

You might as well summon two people and pay them both for digging and filling the hole. No actual hole needs to be dug or filled. The Keynesian assumption is that the digger and filler will spend the money on a hamburger and soda, and thus kick-start additional economic activity.

Keynesian economic thinking overlooks the fact that at the time of the exchange of money, the digger and filler did not create anything of economic value for the person who paid them money. Therefore, this kind of “recirculation of money” leads to no economic growth. In order to further clarify this point, we need to explain how the economy works.

Economics 101 for Keynesians

An economy grows when people use their skills to convert natural resources into goods that generate economic value. When you purchase a shirt from Gap, there were a series of exchanges that happened beforehand to enable that exchange. At the end of the economic value chain, we find farmers exploiting natural resources like air, water and land to produce cotton, and miners mining minerals to help produce agricultural tools and fertilizers. All the links in this series of monetary exchanges will lead down the path where something of economic value is created through exploitation of natural resources. Human beings progressed from caves to skyscrapers by producing more and more goods of economic value.

Without creation of value, there is no economic growth.

However, not all exchanges produce economic value.

Take the example of theft. A poor thief picks the pocket of a rich person and then spends the money on daily necessities. Corrupt government employees pilfer money collected from taxpayers and spend it. At the point of exchange of money, theft via pickpocketing or corruption, no economic value is realized by the person from who the money was stolen. Therefore, such monetary exchanges do not lead to economic growth.

An efficient exchange in one in which people paying money derive economic value out of the exchange. Conversely, an exchange that yields no economic value to the payer is an inefficient exchange. A growing economy is one in which the growth rate of efficient exchanges is much higher than that of inefficient exchanges. The opposite is true for stagnant or regressive economies.

This explains why large welfare states typically lead to slow or negative economic growth. Welfare is equivalent to politicians and bureaucrats stealing (at gun point) from some people and giving it to other people via taxation and redistribution. The exchange from taxpayer to welfare recipient does not create any economic value to the taxpayer. It is an inefficient exchange.

Imagine monetary exchanges to be like cogs of a wheel. Welfare spending by government is equivalent to missing cogs. Unnecessary regulations and inefficient government spending are like worn out cogs. Tax and spend policies, and monetary stimulus may make the wheel spin faster, but it does not transmit more power. Keynesians invented terms like ‘liquidity trap’ to explain away their failures such as massive monetary stimulus leading to measly economic growth in US and Europe after the 2008 economic crisis. Japan is the poster child of Keynesian mess.

The larger the welfare state, the higher the number of inefficient exchanges (or broken cogs), hence slower the economic growth.

All welfare states eventually go bust as the size of welfare state continues to grow relative to the size of the real economy. Some like Greece and Venezuela do it fast. Some like France and Italy do it slow.

In some cases, availability of abundant natural resources like oil could help sustain welfare states for a long time because the real economy grows faster than welfare spending. The moment of truth comes when the price of the natural resource goes down rapidly, as is currently the case with Venezuela. In many developed countries, such as Sweden, welfare is currently possible because of the vast economic ‘wealth’ built up over nearly two centuries of rapid economic growth made possible by free market economic policies. If these nations continue to increase the size of welfare state relative to the real economy, eventually they are bound to run out of other people’s money.

Slower economic growth will leave poor welfare recipients with fewer opportunities to earn their way out of poverty. Welfare spending will never help an economy grow because it is an inefficient exchange. Welfare will only ensure perpetuation of poverty and misery.

Heavy-handed government regulations also contribute to increased inefficient exchanges. The cost of goods and services is much higher in heavily-regulated economies. In most cases, the additional cost resulting from regulations do not create proportionate economic value to taxpayers. This results in additional inefficiency in the economy which leads to slower economic growth.

Even non-welfare expenditure by government is highly inefficient and wasteful. For example, government infrastructure projects are almost always beset by huge cost and schedule overruns. The additional expenditure does not create proportionate economic value for taxpayers.

The easiest way to ensure an economy is dominated by inefficient exchanges is to concentrate the power in the hands of a dictator, an oligarchy, or even a democratically-elected government, also known as central planning. An economy dominated by heavy government expenditure and shackled by regulations will result in trillions of exchanges that result in no value creation. Money just changes hands between people.

The easiest way to guarantee an economy is overwhelmingly dominated by efficient exchanges is to ensure prevalence of free market conditions where individuals are free to spend their money where they see fit. The key to free markets is that both parties engage in an exchange in the absence of coercion (violence or threat of violence).

The lesson for Keynesians is that merely increasing the circulation of money through forcible redistribution does not generate economic growth.

The Keynesian hole is not one you can fill unless you stop digging first and allow free markets to flourish.

* Satish Bapanapalli has been an ardent admirer of Milton Friedman’s ideas since 2009. Satish’s ideas closely resonate with libertarian or classical liberal philosophy.

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