The revival of a costly myth

The revival of a costly myth
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First Published: Wed, Nov 19 2008. 10 24 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Wed, Nov 19 2008. 10 24 PM IST
Despite having a stake driven through its heart after being identified as the primary cause of the stagflation of the 1970s, a failed economic policy has risen from the dead. Yet, the consensus at the recent G-20 meeting is that governments can create jobs and end recessions simply by spending more money.
Illustration: Jayachandran / Mint
The myth that higher public spending is good economic policy is so resilient that its supporters are unperturbed by all the evidence that contradicts it. Consider that Japan’s policymakers began throwing massive amounts of money at the economy in the late 1980s to reignite it. This constant flow of deficits brought only a growing mountain of public sector debt with the economy regaining its long-term growth trajectory. Nor did it deter Japan from ushering in yet another recession.
More recently, the Economic Stimulus Act of 2008 gave so-called tax rebates worth $100 billion to US households in May, June and July. But the rise in spending was very small since most went into savings, including paying down debt.
Numerous studies show that one-time tax rebates cannot bring higher economic activity. This is because temporary increases in disposable income do not create incentives to increase consumption over time. The only certain thing is that stimulus packages based on increased public sector deficit will add to national debt.
Belief in the efficacy of deficit spending rests on a naïve notion that consumption is an important driver of economic growth. It is as though consumer goods and services are merely gifts of nature.
In reality, the path for sustainable economic growth requires more savings so that there can be more capital goods. As it is, capital goods are the basis of higher output and increased wages by boosting productivity. The provision of capital goods requires that consumption be deferred.
It seems that saving is not only a natural instinct, but it is also promoted by many fables, biblical and otherwise, that show the merits of thrift. In recent years, central bankers removed incentives to save by driving interest rates to unsustainable and artificially low levels while inducing more consumption.
This leads to a “paradox of spending” whereby consumers, deterred from saving by low deposit rates, are lured into low-interest borrowing to boost current living standards. This distortion in credit markets induces individuals to make decisions that lead to greater misery in the future for them and for others. Indeed, increased spending may cause incomes to fall by a greater amount since the attempt to buy more today backfires as there are fewer jobs and less to consume later.
Therefore, policies that aim to raise consumption now lead to less capital being available for future production, so there will be less future consumption.
An enduring fable has it that governments can “create” jobs either through public spending to employ people in the public sector or to increase overall demand. During his campaign, Barack Obama promised to use $150 billion to promote windmills, solar panels and “energy efficiency” that would supposedly create five million “green” jobs.
In the first instance, government spending to “create” jobs costs more than jobs created in the private sector, since public sector recruitment involves massive bureaucracies. And since adding workers to the public payroll creates a new burden on taxpayers who have less to spend or invest, this means there can be no net gain to the economy.
In all events, government funding to “create” green jobs may be the worst of both worlds. Much of the support for green projects exists as they are thought to create more jobs because they involve more labour-intensive production. For example, supporters of initiatives for alternative fuels insist they would boost employment than would the building of conventional power stations. But conventional power stations operate with enormous economies of scale that bring lower unit costs so that more jobs can be created throughout the economy.
Job creation based on real economic merit does not require government involvement. But providing subsidies to support inefficient technology raises the labour-to-capital ratio so that the demand for labour will be lower and real wages will fall.
It is bad enough that deficit spending on job creation is simply ineffective. What is worse is that government spending schemes that expand public sector debt impose several burdens on future generations. Most obvious is the additional tax burden they must pay for debts incurred in the present.
By?spending?beyond?their?means to conjure up jobs, governments undermine or eliminate employment that would have been created in the private sector in the future. If increasing the share of GDP claimed by government leads to lower long-term economic growth, “creating” jobs today will mean fewer jobs in the future. The best way to avoid a future of booms and busts is to consign economic theories that support public sector deficits to the dustbin of history.
Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and a visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comments are welcome at theirview@livemint.com
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First Published: Wed, Nov 19 2008. 10 24 PM IST