When the government increases its spending, can it increase total spending?

This is a serious question and just about everyone these days is assuming the answer is yes.  I recently read a nice paper by John Taylor  that argues that the use of countercyclical fiscal policy (other than automatic stabilizers) is not really desirable.  But this is different from asserting that an increase in government spending per se does not increase total spending. I don't know whether Professor Taylor agrees with the argument I present below, but it has been a very long time since I have discussed this issue with anyone.  The reason that I have not discussed it much with anyone is because, as Taylor points out in his paper, for at least the last 15 years there has been widespread agreement that activist countercyclical fiscal policy is usually not effective in stabilizing the economy.  Be that as it may, I don't think that increasing government spending per se can increase total spending.  Here is why.

In order to increase its spending, the government must either borrow the money, or print new money.  If the government increases its spending by printing money, then its policy is no longer an increase in government spending per se, because the printing of additional money is an act of monetary policy.  Hence the only way it can increase its spending as a pure act of fiscal policy is to borrow the money.  But if the government borrows the money, then those that lend to government cannot spend the money themselves, nor can they lend it to someone else, who would spend it.  First consider someone with $10,000 who plans to spend it himself.  The government comes along and decides to borrow another
400 or 500 billion dollars.  Is this going to prevent this person from spending his $10,000?  If the answer is no not only for this person, but also for the 40 million other people from whom the government would have to borrow $10,000, then the government would not be able to increase its spending unless it does something to persuade these people to change their mind. The only way the government can do this is to being willing to borrow at an interest rate higher than that that currently prevails in the market place.  That is, the government can only borrow the 400 to 500 billion dollars in this case by pushing up interest rates enough to persuade spenders to save rather than spend.

    But some potential lenders to the governemt, rather than spend the money themselves, would have loaned their money to someone else rather than Uncle Sam.  They would have loaned their $10,000 to someone else if Uncle Sam does not come along and borrow it.  But the someone else who would have borrowed money surely would have spent the borrowed money. Why else does someone borrow money excpet to spend it?  (Possibly to buy a new car, do home repairs, or to invest in a business--but spend it nonetheless.)  But if that someone else did intend to spend the money, the government, by borrowing the money itself, prevents that someone else from spending the $10,000.  That is, the government's decision to borrow 400 to 500 billion dollars prevents the private sector from spending that money itself.  Hence the government cannot increase total spending by an increase in its own spending if those it borrows from (1) would have otherwise spent the money themselves, or (2) would have otherwise loaned the money to someone else.

     There is one final possibility, however.  This is the possibility that those who would lend the money to Uncle Sam otherwise would have simply held on to the 400 to 500 billion dollars, letting it sit in their bank account or leaving it hidden in mattresses.  Is it possible that there is enough money sitting around for this to happen?  At the time I am writing this the stock of United States currency held by the public is about $830 billion. (I think that about 40% of this is actually held overseas.)  The amount of money held in the form of bank deposits is about $720 billion. So the narrowly defined stock of money is currently a little less than $1,600 billion, with perhaps only about $1,200 held within the United States.  This implies that the economy needs about $1,200 billion worth of money narrowly defined to make its normal transactions.  If people could make their normal transactions with only $800 billion, then it might be possible to persuade them to lend some of it to the government.  But why would Americans hold the money they hold unless they need it to make their normal transactions?  Any money not needed for normal transactions can be deposited in bank accounts that pay more interest than currency (which pays none) or the type of checkable deposits that are included in the narrowly defined money stock.  Hence, if there is enough money sitting around in bank accounts that people could use to lend to Uncle Sam, it must be in accounts which depository institutions are already using to lend to other borrowers.  That is, it is unlikely that there are "idle" holdings of money that the general public would or could use to lend to the government to finance an increase in government spending.

    There are macroeconomic models in which increases in government spending cause an increase in total spending.  Within the IS-LM model, the model developed by John Hicks, what happens is actually consistent with the above.  Within the IS-LM model an increase in government spending financed by borrowing does increase total spending but only because the resulting increases in the rate of interest cause households and business to wish to hold less money--that is, part of the lending to the government comes from the decision of households to hold less money relative to their income.  If increases in the rate of interest do not cause people to wish to hold less money, then the increase in government spending will not cause an increase in total spending within the IS-LM model because the LM curve will be vertical.

As a result, it must be concluded that the recently passed stimulus package will not help the United States economy recover from the current recession.

25th Wedding Anniversary

 

It snowed today. I took some pictures, and when looking at them I found this picture taken at a party given for us to celebrate our silver wedding anniverary. It was also in celebration of my father-in-law's 75th birthday, my daughter and niece graduating from college and my wife's uncle and aunt's 50th wedding anniversary. The party was in September 2008, the day University of Alabama played Tulane. The anniversary date was July 30, 2008.

The Economic Incidence of a Tax--part one

There is no doubt that the recently passed economic stimulus package will not stimulate the United States economy. The Obama administration is now going to turn its attention to the budget deficit. But why? If the stimulus package is good for the economy, balancing the budget must be bad. There are no economic models that specify otherwise.

Since the 1960's research on the effect of fiscal policy (government spending and taxing policy) has shown that tax cuts and increases in government spending do not stimulate the demand side of the economy. Tax cuts, however, do reduce the deadweight loss to society from taxes. Tax increases, which is what the Obama administration is going to propose to reduce the government's budget deficit, will increase the deadweight loss to society from taxes.

A deadweight loss is a loss to one group in society that is not offset by a gain elsewhere. Taxes collected are not a loss to society as a whole because they might be used to allow the government to provide a valuable good are service (such as national defense, the legal system, and possibly highways, etc.). The deadweight loss comes from the reduction in economic activity caused by the tax. If the gain from a transaction between a buyer and a seller is $5, but the government imposes a $6 tax on the transaction, it will cause the transaction to disappear.

Suppose I could work an extra hour and earn $75. My gain from working an extra hour is not $75, rather it is $75 minus the opportunity cost of my time. Suppose the cost of my time is $50. That is, if the pay for my extra hour's work is less than $50, I will not work the extra hour. If the government taxes me at a rate of 34%, and I am paid only $75 for working one more hour, then I only have $49.50 after taxes, an amount less than my $50 opportunity cost of working an extra hour.
Hence, I do not work the extra hour.

It is odd to me that many people do realize how high are marginal taxes (the taxes from working an additional hour or earning an additional dollar) in the United States. A self-employed person pays 15.3% of his earning in social security and medicare taxes (although part of this is deductible), while both employer and employee pay 7.65% of each dollar earned, for a total tax rate of 15.3%, up to earnings of $106,800. In 2009 a couple that is married, filing jointly with a taxable income of $70,000 will pay a tax of 25% on each additional dollar earned. If both husband and wife are working, they will also both have incomes below the $106,800 ceiling on social security taxes. Hence for each additional dollar they earn, they pay about 40% in federal taxes. If there is a state income tax, the tax rate for a taxable income of $70,000 is above 4% in nearly all states that have an income tax. This makes their marginal tax rate 44%. Finally, where I live state and local sales taxes total 9%. Hence for each dollar earned and spent, about 53% goes to local, state and federal governments. (The state income tax rate is actually 5% where I live, so the total tax rate is 54%.) A husband and wife who jointly have a taxable income of $70,000 are not poor, but they certainly are not rich. But if they decide to work hard to earn extra money, they will find that various governments in our dear country get a larger share of their additional earnings than they do.

Gee, is this fair?

I don't think it is, but the Obama administration does. They argue that they can increase tax rates on those earning much higher incomes, say those who earn more than $250,000 per year. But there are not that many people who earn that much. Besides, if the tax rate on an additional dollar earned becomes as high as 60 or 70%, people who are capable of earning incomes over $250,000 will figure out ways to earn their incomes in a manner that is not taxable or they might even decide not to earn it at all.

It will be interesting to see whether the current administration can tax the private sector heavily without destroying it. Finally, it will interesting to see if the administration can figure out the fact that the economic incidence of a tax is different from the statutory incidence. If my income is taxed at a rate of 55%, then I pay 55 cents in taxes for each additional dollar that I earn. But because the high tax rate causes me to reduce the number of hours that I work, I don't produce as much output as otherwise. The reduction in my output can make someone else worse off. If I were a physician and decided to take longer vacations because of my high marginal tax rate, and/or charge more for my services, it would make my patients worse off. They might be poor.
My next post will discuss this further.

Wall Street Journal does not understand Economics

I am getting increasingly frustrated with the Wall Street Journal. Its writers do not understand economics well enough to write a decent article.

This is only the beginning, I think

I have just set up my very own blog.
I hope to have something useful to say.
Sincerely,
The Ancient Professor