I’d like to share a counterintuitive argument against the concept that budget deficits and/or infrastructure spending consititute effective economic stimulus. It comes from Paul Kasriel (one of my favorite reads when he was at Northern Trust, before he retired). He always has a way of looking at things from different angles than everybody else does.

Paul notes that the post-election US stock market rally has been due in part to the expectation that the Trump administration will enact stimulative fiscal policies, which in turn will jumpstart growth. But Paul begs to differ on that last point.

He tells us that after some years out in the real world, he realized that tracing through where government gets the funds to finance tax cuts and increased spending is the most important issue in assessing the potential effects of stimulative fiscal policy.

Paul engages us in a thought experiment to make his case. I think I’ll just step aside and let him lead the way. He got me thinking, that’s for sure.

Do Larger Federal Budget Deficits Stimulate Spending? Depends on Where the Funding Comes From

By Paul Kasriel

The U.S. equity markets have rallied in the wake of Donald Trump’s presidential election victory. Various explanations have been given for the stock market rally. President-elect Trump’s pledge to scale back business regulations are favorable for various industries, especially financial services and pharmaceuticals. Likewise, President-elect Trump’s vow to increase military spending is an undeniable plus for defense contractors. But another explanation given for the post-election stock market rally is that U.S. economic growth will be stimulated by the almost certain business and personal tax-rate cuts that will occur in the next year, along with the somewhat less certain increase in infrastructure spending. It is this conventional –wisdom notion that tax-rate cuts and/or increased federal government spending stimulate domestic spending on goods and services that I want to discuss in this commentary.

Although I have been a recovering Keynesian for decades, I got hooked on the Keynesian proposition that tax-rate cuts and increased government spending could stimulate domestic spending after having taken my first macroeconomics course way back in 19 and 65. I was so intoxicated with Keynesianism that I made a presentation about it in a political science class. I dazzled my classmates with explanations of the marginal propensity to consume and Keynesian multipliers. My conclusion was that economies need not endure recessions if only policymakers would pursue Keynesian prescriptions with regard to tax rates and government spending. Reading the body language of my classmates, I believed that I had just enlisted a new cadre of Keynesians. That is, until one older student sitting in the back of the class raised his hand and asked the simple question: Where does the government get the funds to pay for the increased spending or tax cuts? I had to call on all of my obfuscational talents to keep my classmates and mein the Keynesian camp.

When I graduated from college with a degree in economics, I still was a Keynesian, perhaps a bit more sophisticated one, but not much. At graduate school, I became less enchanted with Keynesianism. But Keynesianism is similar to an incorrect golf grip. If you start out playing golf with an incorrect grip, you will have a tendency to revert to it on the golf course even after hours of practicing at the driving range with a correct grip. Bad habits die hard. So, even though I had drifted away from Keynesianism, it was easy and “comfortable” to slip back into a Keynesian framework when performing macroeconomic analysis. Yet, I continued to be haunted by that question my fellow student asked me: Where does the government get the funds to pay for the increased spending or tax cuts?

I guess I am a slow learner, but after a number of years in the “real world”, away from the pressure of academic group-think, I realized that tracing through the implications of where the government gets the funds to finance tax-rate cuts and increased spending is the most important issue in assessing the stimulative effect of changes in fiscal policy. And my conclusion is that tax-rate cuts and increased government spending do not have a significant positive cyclical effect on economic growth and employment unless the government receives the funding for such out of “thin air”.

Let’s engage in some thought experiments, beginning with a net increase in federal government spending, say on infrastructure projects. Let’s assume that these projects are funded by an increase in government bonds purchased by households. Let’s further assume that the households increase their saving in order to purchase these new government bonds. When households save more, they cut back on their current spending on goods and services, transferring this spending power to another entity, in this case the federal government. So, the federal government increases its spending on infrastructure, resulting in increased hiring, equipment purchases and profits in the infrastructure sector of the economy. But with households cutting back on their current spending on goods and services, that is, increasing their saving, spending and hiring in the non-infrastructure sectors of the economy decline. There is no net increase in spending on domestically-produced goods and services in the economy as a result of the bond-financed increase in infrastructure spending. Rather, there is only a redistribution in total spending toward the infrastructure sector and away from other sectors.

What if a pension fund purchases the new bonds issued to finance the increase in government infrastructure spending? Where does the pension fund get the money to purchase the new bonds? One way might be from increased pension contributions. But an increase in pension contributions implies an increase in saving by the pension beneficiary. The pension fund is just an intermediary between the borrower, the government, and the ultimate saver, households or businesses saving for the benefit of households. Again, there is no net increase in spending on domestically-produced goods and services in the economy.

What if households or pension funds sell other assets to nonbank entities to fund their purchases of new government bonds? Ultimately, some nonbank entity needs to increase its saving to purchase the assets sold by households and pension funds. Again, there is no net increase in spending on domestically- produced goods and services in the economy.

What if foreign entities purchase the new government bonds? Where do these foreign entities get the U.S. dollars to pay for the new U.S. government bonds? By running a larger trade surplus with the U.S. That is, foreign entities export more to the U.S. and/or import less from the U.S., thereby acquiring more U.S. dollars with which to purchase the new U.S. government bonds. Hiring and profits increase in the U.S. infrastructure sector, decrease in the U.S. export or import-competing sectors.

Now, let’s assume that the new government bonds issued to fund new government infrastructure spending are purchased by the depository institution system (commercial banks, S&Ls and credit unions) and the Federal Reserve. In this case, the funds to purchase the new government bonds are created, figuratively, out of “thin air”. This implies that no other entity need cut back on its current spending on goods and services while the government increases it spending in the infrastructure sector. All else the same, if an increase in government infrastructure spending is funded by a net increase in thin-air credit, then there will be a net increase in spending on domestically-produced goods and services and a net increase in

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