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Keynesians believe that government spending can make up a shortfall in private demand. Their models assume that--in an underperforming economy--government spending adds money to the economy, taxes remove money from the economy, and so the increase in the budget deficit represents net new dollars injected. Therefore, it scarcely matters how the dollars are spent. Keynes is said to have famously asserted that a government program that pays people to dig and refill ditches would provide new income for those workers to spend and circulate through the economy, creating even more jobs and income.
The Keynesian argument also assumes that consumer spending adds to immediate economic growth while savings do not. Applying this reasoning, the Keynesians believe unemployment benefits, food stamps, and low-income tax rebates are among the most effective stimulus policies because of the likelihood that recipients will spend rather than save.
Taking this analysis to its logical extreme, Mark Zandi of Economy.com has boiled down the government's influence on America's broad and diverse $14 trillion economy into a simple menu of stimulus policy options, whereby Congress can decide how much economic growth it wants and then pull the appropriate levers. Zandi asserts that for each dollar of new government spending: temporary food stamps adds $1.73 to the economy, extended unemployment benefits adds $1.63, increased infrastructure spending adds $1.59, and aid to state and local governments adds $1.38. Jointly, these figures imply that, in a recession, a typical dollar in new deficit spending expands the economy by roughly $1.50.
Over the past 40 years, the Keynesian theory of government spending as stimulus has lost favor among many economists because the “theory” has been contradicted both by empirical data and economic logic.
In fact, economic data contradict the Keynesian theory. For instance, despite the historic 7 percent increase in GDP deficit spending in 2008, the U.S. economy shrank by 2.3 percent in FY 2009.
Contrary to what the Keynesians want us to believe, this is no longer a theoretical exercise. The idea that increased deficit spending can cure recessions has been tested repeatedly, and it has failed repeatedly. The economic models-like the one suggested by Mark Zandi- that assert that every $1 of deficit spending grows the economy by $1.50 cannot explain why $1.4 trillion in deficit spending did not create a $2.1 trillion explosion of new economic activity.
In fact, Congress cannot create new purchasing power out of thin air. If it funds new spending with taxes, it is simply redistributing existing purchasing power (while decreasing incentives to produce income and output). Every dollar Congress spends must first come from somewhere else.
From where does the government acquire the money it pumps into the economy? Congress does not have a vault of money waiting to be distributed. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another.
Removing water from one end of a swimming pool and pouring it in the other end will not raise the overall water level. Similarly, taking dollars from one part of the economy and distributing it to another part of the economy will not expand the economy.