Spending Does Not Drive the Economy, Part 1
The belief that spending drives the economy is pervasive. It manifests itself in two sub-categories: First, the belief that consumer spending drives the economy and, second, the belief that government stimulus spending assists the economy.
We’ll look at each of these in turn, and then show how this relates to the topic of productivity.
Consumer Spending Does Not Drive the Economy
Over the years we’ve often been exhorted, such as after 9/11, to go out and spend money in order to help stimulate the economy. This is also the thinking behind the stimulus checks that are sometimes sent out.
The media also routinely assumes this notion in its reporting. A few years ago, many news outlets were astonished that we were not yet in a recession, and credited the American consumer as propping up the economy through ongoing spending habits (which they called “irrational”). In our current state, the drop in consumer spending is thought to be a bad thing for the economy.
But it is pretty easy to see the fallacy in the idea that consumer spending stimulates the economy. Here’s a short example to show why.
Let’s say that the “economy” of my family is in bad shape. Do my wife and I conclude that it’s “time to go spend more money” so that we can get things back on track? Clearly not. That would be a devastating course of action. Instead, we would embark on two strategies: (1) save more and (2) earn more money (= produce more goods and services of value).
The same holds true when we think of the economy as a whole. Nothing changes simply by increasing the number of people in the predicament.
To illustrate this, let’s say that there were 300 people in my family and we were running out of food. Would that change anything about the need for our fundamental strategy of saving more and producing more? No. We’d have more people to produce things, which would be a benefit, but nobody would say “hey, we’re short on food, so let’s start eating more!”
Does anything change if we extend this out to 3,000 people? Or 300,000? Or 300,000,000? Not at all. The reason is that there is still a finite amount of resources. We cannot invent economic goods out of thin air.
I’m not saying that there is no role for spending in the economy. I’m saying that saving and earning must come first. You cannot spend unless you have something to spend.
Government Stimulus Spending Does Not Stimulate the Economy
Now let’s talk about government spending. Does government stimulus spending, such as on public works projects, somehow stimulate the economy?
Well, the first thing to realize here is that wealth is not generated by the mere fact of spending. Simply spending money on just anything doesn’t help the economy. When money is spent, if it is going to be beneficial for the economy, it must be spent on the right things.
Let me build on the above example to illustrate this.
Let’s say that Heidi and I have earned more and saved more, and now we have some money to spend. We observe that the rest of our neighborhood remains in a depressed economic state, and we want to help out.
Should I go to my neighbor and say “hey, why don’t you dig a hole in my backyard here? I’ll pay you $100. Then, the next day I’ll fill it back up so that you can then dig it out again and receive another $100.”
Have we enhanced the economy of our neighborhood through this spending? Not at all. I’ve just transferred $200 from my pocket to his, but nothing of value has been produced. In fact, I’ve wasted his time. And I now have $200 less to spend on something that really would make a difference.
What we see here is that the mere fact of spending does not in itself advance the economy. It needs to be the right kind of spending — on useful things.
So, how do we know what things will be useful to people? This is what profit and loss are for.
A business has to prove that a project will likely be profitable (= desired by people to the point that it will generate more value than it cost). This weeds out projects that seem like “good ideas” but would not in fact be desired by society.
Further, if a business makes a bad investment, that project will not be profitable and the business will have to end it — thus freeing up resources that had been devoted to the unprofitable project so that they can be used for more desired things.
The government has no such test to demonstrate what initiatives truly will match consumer demand, because the government does not operate under profit and loss. Now, I’m not saying government should — that’s not the nature of government.
Which means: government should not be in the business of trying to do “public works” projects to stimulate the economy. It shouldn’t be in the business of doing that because it has no reliable method of truly knowing which projects would match consumer demand and be of benefit to the economy.
Yes, government can make educated guesses based on extensive studies. But since government does not operate within a profit and loss system, in the end that is like a scientist developing hypotheses but never testing them. In economics, the true test of whether an initiative meets customer demand is whether it makes money. Studies are great, but the proof is in the actual results of profit and loss.
Businesses exist to do business, not the government. The government should let businesses do their job, and not attempt to “help the economy” by embarking on deficit spending to fund public works projects.
In Fact, Government Spending on Public Works Impoverishes the Economy
Now, here’s the real tragedy.
Someone might say “what’s the harm? Let businesses do their thing, and government will supplement that with its public works spending.”
This objection forgets our finitude.
(In fact, all of economics is about acknowledging the fact that we are finite. Our finitude is not only individual. It is also collective.)
To see the problem here, we need to realize where government gets its money. Government doesn’t produce things which it then sells at a profit, like businesses do. Instead, it gets its money from people and businesses.
Here’s what that means: Since the government gets its money from the people and businesses, when it spends or invests that money in projects that do not match consumer demand, it is diverting money away from projects which would match consumer demand.
Hence, there is less money available in society to fund the initiatives that are in alignment with consumer wants and needs. As a result, the economy is impoverished, not assisted, by public works projects.
How This Relates to Productivity
This relates to productivity in multiple ways. First, as I discuss in some of the founding posts on this blog (see the About page), productivity is about more than simply our own personal productivity. We ourselves need to be productive, but so also do the organizations we work for and the society that we live in. It is not all about us.
We are part of a larger context, and so we need to seek the good and productivity of our organizations and society, not just ourselves. Just as there are principles on how to be effective personally, there are also principles that demonstrate what will be productive at the organizational and societal levels as well. We should know these principles so that we can be more effective in serving the broader world.
Second, this relates to productivity in that bad economic policy undermines your personal productivity. Working in a good economy amplifies your efforts. If you are productive personally, the results of that will have a broader effect because your effectiveness will then be amplified by the effectiveness of your organization and the economy generally.
But bad economic times can de-amplify the outcome of your productivity. When the economic environment is bad, the efforts of your company which you contribute to may be less effective generally — meaning that the impact of your productive efforts in support of your organization’s goals will be less than it would have been.
A bad economy, however, does present other unique opportunities. It forces an even greater “entrepreneurial gap,” for example, sparking greater creativity. And the need for productivity in general is even greater in a tough economy.
But making your organization more effective in tough economic times is not the end goal. We want things to turn around so that we can amplify the good results of our efforts even more. Understanding good economic policy, even in a small way, can perhaps in some way serve to help that time to come.
In sum, we’ve seen three things here. First, consumer spending does not drive the economy because it is saving and earning that improve the economic condition of society, not buying and consuming.
Second, government spending is no exception to this. In fact, government stimulus spending hinders economic growth the economy grows through investment in the right things, not just any things — and government does not have the means to know what those things are. As a result, government spending has a detrimental effect because it diverts money away from those who are in a position to invest it in demonstrably useful projects.
Third, we’ve seen that this matters to the issue of productivity because the productivity of society is an important component of productivity in general. Further, poor economic conditions can undermine the multiplied benefits of personal productivity. At the same time, the value of personal productivity becomes even more critical in difficult economic times.
Last of all, by understanding the big picture of sound economic policy we can, in some small way, perhaps see ways that we can be a part of the solution when it comes to the healing of the wider economy.