Today our government basically follows the policies advocated by the famous 20th century economist John Maynard Keynes. In simple words, Keynes believed that the capitalist free market system should be left alone as long as it works but that the government should step in whenever it doesn’t. A hundred thousand houses are an asset for any nation, Keynes wrote, but a million unemployed are a liability. So, when we need houses and have unemployed, why not let them build the houses, even if the government has to hire them to do so?
These days, both Democrats and Republicans seem to agree with this philosophy, but there is a basic difference: Democrats want to put emphasis on increasing direct government expenditures; Republicans want to see more tax cuts so, as they put it, people themselves can decide what to spend their money on. Which is the better policy to mitigate our current economic situation? Let us see.
It is clear that to increase income and employment, money must be spent. One of the most important issues that beginning economics student have to learn is that income equals expenditures. Nobody can spend a penny without someone earning it, and no no one can earn a penny without someone spending it. You may believe that our city, state, or federal government should spend less, and at times you might be right; but what you must realize is that any dollar not spent is a dollar not earned.
Whether that money is spend on street repairs, renovating dilapidated school buildings, or hiring more teachers, it does increase income and employment. And it does not stop there; there is what economists call the multiplier effect. The formerly unemployed who now have an income will pay some of it in taxes, may save some of it and will spend the rest. What they spend will become income to someone else, who again will spend part of it and so increase further income.
But what if the government spends the money on “pork,” on a bridge to nowhere? That is obviously much less desirable than spending it on education, health care, the protection of the environment or other socially desirable endeavors. However, even building a bridge to nowhere does create income and jobs and has the multiplier effect. Keynes argued that even taking half of the unemployed and letting them dig holes in the ground and take the other half and letting them fill the holes up again is better than doing nothing, as long as the goal is to curtail a recession.
So how about tax cuts? Tax cuts, I am afraid, do not accomplish the same, because the recipients of these tax cuts may not spend the money; and the larger the taxpayer’s income and wealth, the lower is what economists call the “marginal propensity to consume,” that part of any additional income that is spent.
Suppose you are financially relatively well off, your house is paid for, you have nice savings, and the annual income for you and your spouse is $1,350,000. Now you get the $800 provided for in our current stimulus package for most taxpayers. By how much will you increase your expenditures? I would say that you probably would not buy anything that you would not have bought anyhow. But give $800 to a poor couple who doesn’t have money to buy enough food and also heat their small apartment adequately, and who may not earn enough to pay taxes anyhow. You bet they’ll spend it all immediately.
But how about investments? Would higher income earner not spend money on investments? Let’s suppose, then, that you are a manufacturer who produces ladies’ dresses and accessories, and because of our current recession your sales have dropped to half and you had to lay off some of your employees. Now you get a $20,000 tax cut. Will you now hire your laid-off workers again if you can’t sell the things you have on hand? Hardly.
You may use the money to pay back a loan you owe to your bank. Banks like to lend out money; after all their income comes from the interest paid on loans. But they will not lend out money these days to people, businesses or institutions that may not be able to repay the loans. So the money you paid to the bank will stay there, it has changed hands only once and the multiplier will is one.
A super conservative, on the other hand, might argue that the government has no business interfering in the economy like that, with huge, uncalled for, unnecessary expenditures because, in the long run, the free market itself, if left alone, will take care of matters by itself. Keynes had an answer to that one also: “In the long run,” he wrote, “we’ll all be dead.”