The basic Keynesian stimulus argument goes something like this: If the US federal government engages in deficit spending during a recession, the added government expenditures (unaccompanied by tax increases) will boost "aggregate demand." Greater federal spending on a road, for instance, will create jobs for construction workers, who can then spend their additional income on, say, bread. Bakers now will have more to spend on, say, cars and so on, says Richard B. McKenzie, a professor in the Merage School of Business at the University of California, Irvine.
National income stimulated by the initial government road project can grow by some multiple of the expenditure, Keynes' theory says. A stimulus package (and budget deficit) of $1 trillion would morph into a minimum of $1.5 trillion in additional national income maybe even into $4 trillion or $10 trillion.
But if it sounds too good to be true, it is, says McKenzie.
If such income growth were possible, the country would be awash in prosperity, given that the federal government increased the national debt by $1.88 trillion in fiscal 2009 and could run deficits of $1.6 trillion and $1.3 trillion in fiscal 2010 and 2011, respectively.
Between 2012 and 2015 it will add at least another $3 trillion to the national debt.
As economist Milton Friedman observed, when the government engages in deficit spending, it must borrow the extra funds from someone who could have spent them on private-sector projects. Thus, an increase in government spending could be totally offset by a decrease in private spending, as lendable funds are diverted from private to government uses. The net effect can be no net increase in aggregate demand and no multiplier effect. Indeed, with the inevitable waste in government stimulus projects, the multiplier effect could as easily be negative as positive, says McKenzie.
Source: Richard B. McKenzie, John Maynard Keynes, R.I.P., Freeman, October 2010.
For text: http://www.thefreemanonline.org/featured/john-maynard-keynes-r-i-p/#
For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17
First published by the National Center for Policy Analysis, United States
FMF Policy Bulletin/ 05 October 2010