Despite Keynesian Fantasies, Redistribution Does Not Stimulate Growth

IRS building in New York. (Photo: Mario Tama/Getty Images)

Back in 2010, then-House Speaker Nancy Pelosi actually claimed that paying people not to work would be good for the economy. Wow, that’s almost as bizarre as Paul Krugman’s assertion that war is good for growth.

Professor Dorfman of the University of Georgia remembers Pelosi’s surreal moment and cites it in his column in Forbes, which debunks the Keynesian assertion that handouts create growth by giving recipients money to spend.

It is true, of course, that the people getting goodies from the government will spend that money, which also means more money for the merchants they patronize.

People who favor redistribution for other purposes often try to convince others to support them on the grounds that their favored policies will also create economic growth. …let’s review the story as told by those in favor of redistribution. When the government provides benefits to people without much income or spending power, those people will immediately go out and spend all the money they receive. This spending creates an economic multiplier effect as those who get the dollars re-spend some of them… There is nothing particularly wrong with the above story as far as it goes. Economic spending does create more spending as each person who gains income then spends some of that income somewhere else.

But there’s always been a giant hole in Keynesian logic, as Prof. Dorfman explains.

The redistribution advocates always forget to consider one part: where did the money handed out in government benefits come from? …There are three possible answers to that question: the money was raised in taxes, the money was borrowed from an American, or the money was borrowed from abroad. The fact that the money came from someplace is the key because for the government to have money to hand out it must first take it from somebody.

I would add a fourth option, which is that the government can just print the money. But we can overlook that option for the moment since only true basket cases like Venezuela go with that option. And even though we have plenty of policy problems in America, we’re fortunately a long way from having to finance the budget with a printing press.

So let’s look at Dorfman’s options. When governments tax and borrow from domestic sources, all that happens is that spending get redistributed.

If the government raised the money in taxes, then the people paying the taxes have less money to spend in the exact amount that is going to be handed out. …somebody’s spending power was reduced by the exact amount that somebody else receives. …If the money is borrowed from an American, the same thing happens. The person lending the money now either doesn’t spend the money or cannot save the money. When money is saved, banks lend it out. That borrower intends to spend the money (otherwise, why borrow?). When the money is lent to the government instead of being put in the bank, the loan and associated spending it would have created disappear.

And the same is true even when money is borrowed from foreign sources.

…the final hope for economic growth from government transfers would be if the government borrowed the money from abroad. This could work, as long as the money otherwise would not have appeared in the U.S. economy. For example, if China sells us products, they end up with dollars. The question is: if they don’t use those dollars to buy Treasury bonds, what will they do instead? The answer is that the dollars generally have to end up back in the U.S. Even if China turns those dollars into euros and buys German bonds instead, somebody else now owns those dollars and will spend them in the U.S. in some fashion (buying products, companies, or investments).

Prof. Dorfman explains that Keynesianism is merely a version of Bastiat’s broken-window fallacy.

…the claimed economic stimulus from giving money to the poor is offset by the lost spending we do not get from the original holder of the money. …this is a classic example of a famous economic principle: the broken window fallacy. In the fallacy, townspeople rejoice at the economic boost to be received when a shopkeeper must spend money to replace a broken window. What they miss is that absent the broken window, the shopkeeper would have bought something else with her money. In reality the economy is unchanged in the aggregate.

Well said, though allow me to augment that final excerpt by pointing out that the economy actually does change when income is redistributed, albeit in the wrong direction.

This is because many redistribution programs give people money, but only if they don’t work or earn only small amounts of income. And less labor in the economy means less output.

In effect, redistribution programs create very high implicit tax rates on being productive, which is why welfare programs trap people in government dependency.

Last but not least, let’s preemptively deal with a couple of Keynesian counter-arguments.

They often argue, for instance, that redistribution is good for growth because lower-income people have a higher “marginal propensity to consume.”

That’s true, but irrelevant. Even if other people are more likely to save, the money doesn’t disappear. As Prof. Dorfman explained, money that goes into the financial system is lent out to other people.

At this point, a clever Keynesian will argue that the money won’t get lent if overall economic conditions are weak. And there is some evidence this is true.

But those weak conditions generally are associated with periods when the burden of government is climbing, so the real lesson is that there’s no substitute for a policy of free markets and small government.

P.S. Here’s the video I narrated for the Center for Freedom and Prosperity about Keynesianism.