The sages at the National Bureau of Economic Research have finally concluded what many Americans have known for months: The United States is in a recession.
Several prominent economists have recommended vast government spending as a cure. In the December issue of the New York Review of Books, Nobel Laureate Paul Krugman wrote: “[P]olicymakers around the world need to do two things: get credit flowing again and prop up spending.” This is the wrong prescription, for a number of reasons.
On the surface, it seems obvious that a recession occurs when people stop spending money. From an individual firm’s point of view, if the demand for its product falls off, it has to cut back its own purchases of materials and lay off workers. On the other hand, if demand picks up, then this is a signal of prosperity.
The firm spends more money itself and puts people to work. If the way to “fix” an unprofitable company is to get consumers to spend money on its product, then it makes sense that the government can end a recession by running massive deficits to boost aggregate demand.
Unfortunately, this simple analysis is deceptive.
The true purpose of an economic system isn’t to “create jobs” or channel a particular number of green pieces of paper into everyone’s wallet on payday. On the contrary, what really matters is that workers are employed productively, so that they take scarce resources and transform them into goods and services that consumers value.
Suppose that the government pays a million people to dig ditches and another million to fill them back up. It is obvious that such a program doesn’t make the country wealthier. Even though the politicians can claim to have created two million jobs, there is nothing tangible to show for their program.
When our hypothetical ditch diggers cash their government paychecks and buy things at the grocery store or the mall, they are simply reducing the amount of goods available for the truly productive people. The same holds, to a lesser extent, for President-elect Obama’s calls for massive spending on infrastructure and other investments as a way to fight the recession.
If the government employs a million people building roads and repairing bridges, that toil at least provides something useful. Even so, we should not fool ourselves into thinking that such extravagant spending is more justified now than it would have been in years past. If it didn’t make sense to devote limited tax dollars to filling potholes during the boom years, then it certainly isn’t justified to spend that money now. Every dollar the government spends translates into fewer resources available to the private sector.
Although the causes are still up for debate, everyone agrees that Americans lived beyond their means during the housing boom. Fooled by rising stock market and real estate values, Americans consumed more — and saved less — out of their disposable incomes than they would have, had they realized the crash was coming.
In light of the new realities, American consumers are doing the rational thing. After living beyond their means for years, they are now trying to tighten their belts in order to replenish their tattered savings.
On a physical, macro level, raw materials and workers need to be reshuffled away from sectors such as housing and financial services, and into other areas that were stretched thin during the boom years. This period of retrenchment and readjustment is painful — they call it a recession. But it is necessary to recalibrate the economy’s complex structure of production after it was so distorted during the boom.
Government efforts to prop up consumption spending hamper the true recovery process. The unsound enterprises started during the artificial boom years need to be liquidated so their resources and workers can be redeployed to better uses. By doing everything in its power to stall this painful readjustment, the government simply prolongs the slump.
Robert P. Murphy is senior fellow in business and economic studies at the Pacific Research Institute.