Brevis from Bob Ewoldt

Ronald Reagan once said, “It isn’t so much that liberals are ignorant. It’s just that they know so many things that aren’t so.” One of those things, recently, that liberals are increasingly espousing is demand economics. I’m hearing it more and more, from MSNBC liberals: “We have a demand problem, not a spending problem.”  Why are liberals wrong about demand-side economics?

The Claim

Here’s the situation as a liberal might explain it:

In an economy that has 10% unemployed people, the government ought to provide an income for the unemployed. By doing so, those unemployed people will necessarily go out and spend all of that money, creating a demand for goods in the economy. A business owner in that economy benefits from that demand (he sells goods to the unemployed), and in turn has profits that go up, and in turn hires another person to help in his business, removing someone from the unemployment rolls.

The business owner also orders more supplies, which creates demands for more raw goods, which in turn employs more people at other companies. At every point in the economic food chain, more goods and people are in demand, and employment increases, the economy improves, and revenues to the government increase.

So, any money that might have been borrowed in order to pay the initial unemployment benefits is gained through economic growth, and the debt is easily paid off, thereby justifying the initial debt.

The middle class emerges once again. The unemployment rate nationally is reduced dramatically. Tax receipts spike. The deficit drops. Everyone wins.

In other words, the government, by borrowing money, can create enough demand to jump-start an economy, and by jump-starting the economy we can pay off debt.

There are several problems with this economic theory:

1. Demand-side economics only take into account short-term goals.
2. Demand-side economics cannot be sustained.
3. Demand-side economics don’t work well when accumulated debt it already holding down the economy.
4. Demand-side economics doesn’t take into consideration other forms of demand.

Why Demand-Side Economics Don’t Work

First, demand-side economics only take into account the short-term. There is a trade-off to borrowing money. When you borrow $250,000 in order to buy a house, sure you inject $250,000 into the economy. However, with that comes some trade-offs. First, you’re locked into those monthly payments for 15 to 30 years. Second, you end up paying $379,443 for the house, not $250,000, depending on your term and interest rate. Third, you might find yourself unable to move if you can’t later sell the house.

Similarly, in a national economy, if we borrow $1 trillion to “stimulate” the economy, we’re locking ourselves into those debt payments for the long-term (see discussion of debt and the economy below). We are also paying a LOT more money for that $1 trillion in the future, which decreases future demand (if you paid for your house in cash, you would spend the $129,443 in interest savings on other things in the intervening 30 years). Finally, by increasing our debt, we will find ourselves unable to other things in the future, if we are paying an increasing amount of money on debt payments. Today, the U.S. is paying between $360 billion and $460 billion per year in debt interest payments, and that is while interest rates are an average of 2.2%. If interest rates rise, as they are expected to do, our interest payments will skyrocket. For every 0.25% rise in interest rates, our interest payments on our national debt will increase $41 billion.

The second problem with demand-side economics is that they cannot be sustained. Stimulus packages, as we’ve seen, don’t always work as we expect that they will. The $787 billion stimulus of 2009 did very little to boost the economy (though liberals will say that it kept us out of a depression), and certainly hasn’t caused enough of a boost to the economy where we can pay back the $787 billion in debt. In fact, I can’t think of any scenario in history where a stimulus has been done, and the debt has been paid back. I’m open to anyone pointing out if I’m wrong on this point. However, it seems to me that when we borrow money for stimulus, we continue to pay interest on that debt ad infinitum.

The third problem with demand-side economics is that it doesn’t work well when accumulated debt is already holding down the economy. In theory, economic stimulus might create demand in an economy, as Keynesians/liberals claim. However, I think it’s more appropriate this way: “economic stimulus might create demand in an economy that’s not weighed down by debt.” A study was done by two Harvard professors, Carmen Reinhart and Kenneth Rogoff, that found that when a nation’s debt reaches 90% of its annual GDP, the economic growth is, on average, 1% lower than when its debt was under 80% of GDP. In other words, a high level of national debt makes it very hard to create economic growth. Many countries in Europe have seen this in the last few years. Japan has had this problem for the better part of 20 years.

The comparison to a family budget doesn’t work very well in this category; but the comparison to a large company may work pretty well. If you have a large company, it could be to your advantage to borrow some money in order to make an investment in equipment or in a marketing campaign, to gain market share or to introduce a new line of products, for example. Many financial advisors will say it’s risky to borrow in order to do these types of things, but we’ll say our hypothetical company will do it anyways. When you have a small amount of debt, this can work splendidly. If your gamble doesn’t pay off, then you can pay for the loan out of profits for the next few years until the loan is paid off. However, if you’ve continually borrowed and borrowed, each time on the “next big idea,” then you will reach a point when your “next big idea” doesn’t pay off, and you cannot make the loan payments, and you default on the loan. Then you’re forced, as a company, to liquidate part or all of the business to pay off the loan, at which point other loans may be called, and your company goes under. Similarly, borrowing money when you’re debt-to-GDP ratio as a nation is at 20% is a much different gamble than when your debt-to-GDP ratio is over 100% (as our is now). Your risk as a nation is higher, and if your gamble doesn’t pay off (as in the 2009 stimulus plan), then you’re stuck with an increased debt that you really cannot afford.

The fourth problem with a demand-side economic model for government is that it doesn’t take into account other (and perhaps better) types of demand. When the government spends money, it’s deciding where that money goes, necessarily making a choice as to what is the best sort of “demand.” In the case of the Obama administration, it decided that the following were the best types of demand to create:

• Increasing food stamp payments
• Construction projects – high speed rail, highway improvements, public housing projects, renewable energy investments
• Increases in Pell grants
• More teachers
• Aid to balance state education budgets
• Payroll tax credit
• Increasing the number of weeks of jobless benefits (unemployment)
• Aid to states for Medicaid spending

Cynically, I think that most of the stimulus spending went to sectors where there was a political motivation to spend money, not where there was an economic motivation to spend money (state government, construction, education). This is the fundamental problem with government-supplied demand-side economic policies: it doesn’t send capital where its use would have the greatest economic effect; it sends capital to where its use has the greatest political effect, often to the detriment of the economy.

An Alternative Economic Solution

Liberals do have a point when it comes to demand. Demand for goods and services is a driver of economic growth. However, pushing money into areas in which it otherwise (in a free market) would not be used is an inefficient use of capital. Capital will, in a free market, find its most efficient path to create economic growth, while the government does not. If, instead of confiscating capital from the private sector in the form of taxes or debt, the government were to leave capital in the hands of the private sector, current and future demand would be created, in the most efficient way possible.

In the initial example above, if the government were to refrain from increasing taxes to fund their stimulus (I’ll deal with borrowing below), then the private sector has that much money with which to create demand in their own ways. For example, if the business owner doesn’t have to pay taxes to pay for the stimulus package, then he might have enough money with which to hire an extra employee, or to start a new product line, or to finance an expansion of his business to another community. Instead of the government dictating where the demand is created, the individuals, businesses and communities are instead creating the demand that boosts the economy.

But what about the government borrowing to fund the stimulus? What could possibly be wrong with that? Borrowing, while creating an immediate demand, decreases future demand. Not only does the government have to pay back the stimulus money at some point, but it also has to pay it back with interest. Our $787 billion stimulus in 2009 will cost us $17.3 billion each year, every year, until we pay back the money, which we are unlikely to do (given our track record of paying back our debt). That $17.3 billion is demand that is removed from our economy every year. That decreases our annual GDP by 0.1% each year, which is not insignificant, given that our annual GDP growth is about 1.3% in this sluggish economy.

Bottom line: Government borrowing to fund stimulus packages may temporarily increase economic output (though not necessarily, as we saw in the 2009 stimulus), but actually decrease economic output over the long run. High government debt also decreases economic output, though to what extent is still yet unknown.

Discussion question: Why do you think liberals fall for the demand-side (Keynesian) economic theory?