While driving home last night, I had the miserable experience of listening to a financial journalist being interviewed about the anemic growth numbers that were just released.
I wasn’t unhappy because the interview was biased to the left. From what I could tell, both the host and the guest were straight shooters. Indeed, they spent some time speculating that the economy’s weak performance was bad news for Obama.
What irked me was the implicit Keynesian thinking in the interview. Both of them kept talking about how the economy would have been weaker in the absence of government spending, and they fretted that “austerity” in Washington could further slow the economy in the future.
This was especially frustrating for me since I’ve spent years trying to get people to understand that money doesn’t disappear if it’s not spent by government. I repeatedly explain that less government means more money left in the private sector, where it is more likely to create jobs and generate wealth.
In recent years, though, I’ve begun to realize that many people are accidentally sympathetic to the Keynesian government-spending-is-stimulus approach. They mistakenly think the theory makes sense because they look at GDP, which measures how national income is spent. They’d be much less prone to shoddy analysis if they instead focused on how national income is earned.
This should be at least somewhat intuitive, because we all understand that economic growth occurs when there is an increase in things that make up national income, such as wages, small business income, and corporate profits.
But as I listened to the interview, I began to wonder whether more people would understand if I used the example of a household.
Let’s illustrate by imagining a middle-class household with $50,000 of expenses and $50,000 of income. I’m just making up numbers, so I’m not pretending this is an “average” household, but that doesn’t matter for this analysis anyway.
Expenses Income
Mortgage $15,000 Wages $40,000
Utilities $10,000 Bank Interest $1,000
Food $5,000 Rental Income $8,000
Taxes $10,000 Dividends $1,000
Clothing $2,000
Health Care $3,000
Other $5,000
The analogy isn’t perfect, of course, but think of this household as being the economy. In this simplified example, the household’s expenses are akin to the way the government measures GDP. It shows how income is allocated. But instead of measuring how much national income goes to categories such as consumption, investment, and government spending, we’re showing how much household income goes to things like housing, food, and utilities.
The income side of the household, as you might expect, is like the government’s national income calculations. But instead of looking at broad measures of things such wages, small business income, and corporate profits, we’re narrowing our focus to one household’s income.
Now let’s modify this example to understand why Keynesian economics doesn’t make sense. Assume that expenses suddenly jumped for our household by $5,000.
Maybe the family has moved to a bigger house. Maybe they’ve decided to eat steak every night. But since I’m a cranky libertarian, let’s assume Obama has imposed a European-style 20 percent VAT and the tax burden has increased.
Faced with this higher expense, the household – especially in the long run – will have to reduce other spending. Let’s assume that the income side has stayed the same but that household expenses now look like this.
Expenses
Mortgage $15,000
Utilities $9,000 (down by $1,000)
Food $4,000 (down by $1,000)
Taxes $15,000 (up by $5,000)
Clothing $2,000
Health Care $3,000
Other $2,000 (down by $3,000)
Now let’s return to where we started and imagine how a financial journalist, applying the same approach used for GDP analysis, would cover a news report about this household’s budget.
This journalist would tell us that the household’s total spending stayed steady thanks to a big increase in tax payments, which compensated for falling demand for utilities, food, and other spending.
From a household perspective, we instinctively recoil from this kind of sloppy analysis. Indeed, we probably are thinking, “WTF, spending for other categories – things that actually make my life better – are down because the tax burden increased!!!”
But this is exactly how we should be reacting when financial journalists (and other dummies) tell us that government outlays are helping to prop up total spending in the economy.
The moral of the story is that government is capable of redistributing how national income is spent, but it isn’t a vehicle for increasing national income. Indeed, the academic evidence clearly shows the opposite to be true.
Let’s conclude by briefly explaining how journalists and others should be looking at economic numbers. And the household analogy, once again, will be quite helpful.
It’s presumably obvious that higher income is the best thing for our hypothetical family. A new job, a raise, better investments, an increase in rental income. Any or all of these developments would be welcome because they mean higher living standards and a better life. In other words, more household spending is a natural consequence of more income.
Similarly, the best thing for the economy is more national income. More wages, higher profits, increased small business income. Any or all of these developments would be welcome because we would have more money to spend as we see fit to enjoy a better life. This higher spending would then show up in the data as higher GDP, but the key things to understand is that the increase in GDP is a natural result of more national income.
Simply stated, national income is the horse and GDP is the cart. This video elaborates on this topic, and watching it may be more enjoyable that reading my analysis.
[…] sometimes wonder whether journalists have the slightest idea of how capitalism […]
give me a break – only people who make tons of money talk like you do – frankly Ive worked for the private sector and their jobs – whoopee—-whole bunch of part time minimum wage jobs – you work a couple of these private sector gems, juggling hours, with no job security, and at the end of the day you cant afford to get your teeth fixed ….your kind of talk is smug and self satisfied. But I am on a quest to learn aboput economics and so I will print this and put it in a file. The private sector minimum wage jobs I have had, generate wealth, for their CEO’s (who are in China by the way.)
And what people like you really want is a kind of slave wage class of people – and you have every intention of expoiting them to the max.
I think the problem is that GDP includes government spending, counted as $1 worth of GDP for each dollar of spending. This obscures what is actually going on, since of course few people would actually spend $1 to buy what government has to spend $1 to produce.
GDP would be a much better measure of the state of the actual economy if it didn’t include government spending, ie, only included items that actual people willingly spent their own money to purchase.
Big government lovers would hate this.
What a bunch of malarkey. instead of assuming the “… tax burden has increased”. assume “taxes went down by 5K, because by investing that money, we’ll get a greater return on it”. We invest the 5k (per year), and lose it because it is pocketed by the people we invested it in, rather than actually being invested.
1st year, 5K debt. 2nd year 10k debt. 3rd year, 15K, etc.
Now, you cut your spending to pay off the debt. (Nevermind the fact that you’re still giving 5K away every year). Now, there is less demand for whatever is generating your income, so your income does down. So you cut your spending even more, and your income goes down again.
Then, the folks taking that 5K say give me another 5K, and they’ll invest it and turn everything around. so you give them another 5K, and they hire someone in China for 1K and pocket the other 4K. So you cut spending more, reducing demand, ad nauseum.
All your rental income is gone, all those people got laid off. You dividend and interest income is gone so you could invest it. Your salary is in jeopardy, because there is no demand for your services.
Option A: cut spending more
Option B: get your 5K back, and then some
Economics is about supply and demand. No demand, no need for supply.
This whole model falls utterly apart with the insertion of 1 thing: greed.
“I repeatedly explain that less government means more money left in the private sector, where it is more likely to create jobs and generate wealth.”
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Unfortunately Mr. Mitchell, the electorate is averse to accepting this simple arithmetic. This is because the money that is left in the private sector is dispersed and thus largely invisible to the voter – even if much more efficiently utilized by the private sector. Voters can perhaps sense that the money left to the private sector is somewhere out there but they cannot quite pinpoint where and, besides, the voter feels a little uneasy that he does not really have direct control over that money.
By contrast, voters feel that money subject to collective management (i.e. government spending) is more under their direct control and, of course, naturally, politicians will never forget to advertise any job creation resulting from government expenditure, no matter how inefficient. Also the big blocks of uniform job creation created by government spending, are easier to pick up and advertise by the media in 30 second news bites, even if each new job costs $200,000. So you are more likely to see the proverbial 10,000 workers building a dam with teaspoons in the evening news, than the 20,000 dispersed and much more effective jobs created by the private sector — had their money not been confiscated to pay the spoon diggers. Voters feel good to see that their tax money is been put to use into something that can be explained in the 30” evening news bite. By contrast, it would take a lot of detective work, or (alas) rudimentary economic intuition, to find out where the 20,000 more efficient private sector jobs have been created. Last, but not least, denial in the existence of competition, feeds many beliefs that money left in the private sector will be unfairly kept by businessmen who apparently send bloody horse’s heads to anyone trying to enter their highly lucrative business and compete with them by doing the same work at a fraction of the supposedly unfair compensation.
Of course, these voter dynamics have been at work in places like Europe and the rest of the world for a very long time. The adoption of such dynamics by American voters is a recent phenomenon and the hallmark of the current administration’s structurally pernicious affects. I do not know which one is the chicken and the egg here, the voters who elected this “mimic the rest of the world” administration, or the administration that bamboozles voters with “lets follow the rest of the world and we will maintain prosperity 6 times world average” messages. But one thing is for sure: Both Chicken and Egg are headed for decline. Already under pressure form 3 billion people who are on the verge of effectively competing with Americans, placing the economy under collective management, declaring war against the most productive members and, at the same time, insulating the less productive from the consequences of mediocrity, hardly seems like an approach that will forestall decline. But since this is nearly impossible to sell to the electorate, decline is inevitable.
The central theme I am becoming more and more aware every day is that, as it turns out, the legendary, prosperity enabling, American spirit of self-determination and self-reliance existed amongst Americans more as a matter of historical tradition rather than rational thought. For a variety of reasons, American voters are now finally reverting to the default behavior of their worldwide cohorts. Convergence to the worldwide average of production, and thus standard of living, will be the inevitable end result — Plan accordingly. Don’t get caught with your pants down!
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Lastly, GDP tells the same story: Decline. Falling to a European level 1-2% growth trendline, in a world that is growing 4-5% per year, is a certain path to your children being demoted to average worldwide prosperity levels, instead of the legendary 6 times world average prosperity enjoyed by today’s American middle class, which, feeling the competitive pressure from the emerging world, has responded by declaring a suicidal war on Steve Jobs and is placing the economy under the same collective management that has kept most of the world behind America. It is hard to see how this all ends well. But things are moving ever faster in the 21st century, so this is no longer a problem for the next generation. We will all feel the decline. It is here today, this is just the beginning….
America is now in rapid transition from the aberrant Cowboy Capitalism that allowed an otherwise mediocre (by world standards) Average American to attain a standard of living 6 times the world average to the commonality of the rest of the world. What will the next equilibrium point be? The French equilibrium point of slower but certain decline? I do not see an optimistic scenario.
Right. Because when the Tea Potters turn the US economy into a $50K household, you ain’t gonna like it.
Oh, good grief. I’d give worlds to be that simple.
I’m going to put this theory that a complex national economy in a global context is just like Joe the Plumber’s economy (if Joe the Plumber actually WERE a plumber), down to what Ron Suskind identified as the epistemology of the Republican Party: “It’s not true but if we keep saying it, it will BE true.”
I’d advise you to stop talking down to the public, but since you’re using “economics for dummies,” I can already tell would that would be futile.
I suppose it is true that “not all spending is equal,” which is why I waste my time at nakedcapitalism.com (We could all use a primer!).
Thanks, Kevin L. I see your point but I’m trying to apply it practically in my mind.
So OK, let’s imagine the Fed does NOT raise the debt ceiling. They take in ~$200 billion/month. They had planned to spend more than that (naturally). So while I totally agree the gov’t spends money foolishly, and on things of less value than the free market would determine, are you saying that simply not spending on stupid stuff adds value elsewhere?
They certainly don’t have money left over from the $200 billion to pay down the debt; they’d be scrambling to prioritize and pay the things they’d have to play (both fiscally and politically, ie. bonds, SS and military payments, etc.).
Really appreciate the discussion!
Benedict and Sanderson,
You are missing the point that not all spending is equal. If that were the case, why bother paying for a college education or tools when you could have more ice cream? Government spending tends to go into consumption and actually *decreases* the value of the inputs rather than increasing them, like a market system guided by profits and loss will. Government doesn’t care if it’s “losing” money, as long as it’s spending something.
When less money goes to consumption, more is either being diverted to paying off debt (meaning someone else gets the value), investment in capital which can be used to create value and wealth, or into savings, which may or may not be going into capital investment. All these things mean not that there is less money, but that it has been diverted to things which people find more valuable or other people who will create value with it. The debtor finds it more valuable to decrease his principal and pay less on interest in the future than have more ice cream today. The saver finds it more valuable to hold onto his cash until something more productive can be done with it. The investor finds it more worthwhile to put money into modernizing an assembly line rather than purchasing art for the lobby.
Value does disappear when money is spent on the wrong things. That is the whole premise of profit and loss in a market economy.
Scott,
1) The family had investment income, so they saved at some point. But I agree with you on the analogous government spending rather than truly investing.
2) Like the video and article say, the government consumption on roads and infrastructure was taken from somewhere else – either the same community, in which case they could have funded valuable things themselves, or other communities who are now less able to meet their needs. There is the case that it came from foreign investment, which means communities, say in China, now have less capital with the expectation of a return of their capital, with accompanying interest, from America (i.e., the next generation of Americans). And since the government’s borrowed funds are in most cases not being put to use increasing their value (creating wealth), the interest will have to come from productive parts of the future economy (if there are any left) in the form of taxes. The only way to more prosperity is using human work and ingenuity to make things that are of more _value_, subjective or objective, than their inputs. And no government-managed system has been able to do this. Only in a market system where individuals exchange what they have for what they value more can wealth be created.
Maybe I’m missing something, but does this show how cutting spending does not HURT a sluggish economy? I run into this argument all the time with Liberal friends, about the debt.
I say we have to cut spending and they ask how that will help the current economy, and insist it will hurt the recovery.
Please give me ammunition (and some education too)!
While you are correct that “money doesn’t disappear if it’s not spent by government,” the rest of your analysis makes the exact opposite mistake, i.e., that money DOES disappear when it is taken in taxes. You may not like government spending, but the fact is that the government spends it right back into the economy faster than a drunken sailor on shore leave. From a macro perspective, that’s all that matters. The rest of it is simply political ideology.
Preaching to the choir, but good job anyway! Two things:
1) You don’t include “savings” in the family budget which is an important Keynsian concept. “Kenynes” might actually work if the federal government had that surplus for a rainy day. But they never do…..it just gets spent.
2) In defense of Keynes, I think an argument can be made that the government can, in times of recession, be more efficient in the deployment of money into the economy. My community is one of those that suffers from 16% unemployment in “construction”. It took until this summer, but those folks are going back to work on needed infrastructure projects (roads, etc.). The market was not going to put those folks back to work increasing the surplus of commercial and family real estate.
Remember, in a Keynsian environment, the government should be prepared to spend on the downswing, so that the private sector can prepare to spend on the upswing.
Household spending is an excellent example. By the way, most journalists aren’t all that good at math, except the sports guys who have to calculate batting averages.
Bravo! This video is a good primer for those who have no degree in economics and haven’t a clue.