All Commentary
Wednesday, November 24, 2010

Paying the Unemployed Does Not Stimulate an Economy

Many in Congress as well as the President and some of his economic advisers have argued that extending the period for paying the unemployed will stimulate the U.S. economy out of its sluggish performance. Would any of them consider as valid an argument that giving money out of their own pockets to an unemployed member of their household would promote the financial prosperity of that household? Would they not correctly see such financial contribution as merely a transfer within the household? Would they also not be eager to nudge the unemployed to get up quickly and find a job?

So why don’t they apply the same logic to the economy as a whole? The only tenable answer is that they are under the spell of the economic miseducation inflicted on the minds of economists and many among the general population by John Maynard Keynes. They believe that consumer spending drives the economy, without having stopped to consider from where consumers get the means to spend.

Consumption Doesn’t Need Stimulation

On their own—that is, in the absence of government handouts in the form of welfare payments or unemployment compensation (funded by taxpayer money)—people acquire the means to spend by earning income from producing and selling goods and services or directly selling their labor services. If they borrowed the money to spend, it must be from someone else who has earned income from production. And as Adam Smith long ago noted in The Wealth of Nations, “[C]onsumption is the sole end and purpose of all production. . . . The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it.”

Why else does anyone work other than to acquire the means to purchase goods and services? That is why consumption spending does not need stimulating. What we currently save out of our incomes is to enable us to smooth out our consumption spending over time or to acquire the means to increase consumption and/or our income-earning capacity in the future.

Such household investments may take the form of bank accounts or bonds to earn interest income, stocks to earn dividends, or educational skills to earn higher future wages and salaries. The only part of our unconsumed income that we do not devote to increasing our future capacity for increased consumption spending is cash hoarding; cash does not earn interest or dividends. But in normal times, when we are not too scared to keep our savings in bank accounts or to purchase stocks or bonds, cash hoarding constitutes a very minor part of our unconsumed income. Meanwhile, what we save is spent by borrowers of our savings, mostly producers of goods and services.

On the basis of these fundamental truths about how people manage their financial affairs and drawing on the wisdom of Adam Smith, Jean-Baptiste Say constructed the thesis now named after him, Say’s Law of Markets, in his 1803 Treatise on Political Economy. It is from production that people earn incomes to purchase those goods and services they themselves don’t produce:

Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have [acquired] this money itself by the sale of productions of our own. . . . It is then in strict reality with their productions that [people] make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands.

The law simply says that “productions can only be purchased by productions” (Say, Letters to Malthus, 1821).

Regarding the need for savings rather than consumption spending to promote economic growth, Say noted that:

The public interest is . . . not served by consumption, but it is served and served prodigiously by saving, and though it seems extraordinary to many persons, not being any the less true as a consequence, the labouring class is served by it more than anyone else. These persons think, perhaps, that the values which the wealthy save out of outlays on their personal pleasures in order to add to their capitals are not consumed [spent]. They are consumed; they furnish markets for many producers; but they are consumed reproductively and furnish markets for the useful goods that are capable of engendering still others, instead of being evaporated in frivolous consumption.

Failing to understand all this, Keynes made a fetish of consumption spending as the engine that drives an economy during the 1930s, especially in his famous book The General Theory of Employment, Interest, and Money (1936). He argued that Say’s Law applies only to an economy in which there is no unemployment or one in which money is not used as a means of exchange. Neither claim is true. However, many an economist has been hooked on Keynes’s miseducation ever since. In macro models legislated unemployment compensation is listed among “automatic stabilizers.” The thinking is that paying the unemployed so they would keep spending will sustain the economy’s so-called aggregate demand. Even if proponents of that view recognized that the government would have to pay the unemployed from its tax revenue (or borrowed funds), they still do not realize that total spending would not change. But unless the government borrowed the additional funds from outside the domestic economy, what it takes from purchasers of its bonds will not be available for private borrowers to spend on investment projects or for their own consumption. Put differently, variations in the level of government spending, besides the portion funded by external borrowing, do not change total spending in the domestic economy.

The Need for New Production

As for stimulating economic activity, it is not the level of consumer spending but new directions in production that make the difference. Entrepreneurs conceiving of new ways to meet economic necessities or desires in the marketplace create new incomes with their positive ripple effects in the economy. Meeting such needs requires that entrepreneurs find the savings, or loanable funds, to acquire the resources to engage in production. Of course, followers of Keynes’s mistaken 1937 view—“The investment market can become congested through the shortage of cash. It can never become congested through the shortage of saving. This is the most fundamental of my conclusions within this field”—do not recognize the necessity of savings to fund investment expenditures. But the fact is that the government’s taxing the employed or borrowing the community’s savings to pay people who are unemployed does not help entrepreneurs in their socially useful task of new wealth creation. This is also how we should recognize the failure of the $787 billion so-called stimulus of February 2009, the subsequent Cash for Clunkers program, and the first-time home purchasers’ subsidies of 2010 to stimulate economic recovery. The money to fund such programs has to be taken from the economy: There is no injection of new money by the government; it effects only a transfer.

Specialization and Trade

Adam Smith in The Wealth of Nations made the salient point: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” The prudence is in the fact that households typically do not aim to be their own tailors, shoemakers, wine makers, homebuilders, or producers of all the numerous things they need, but rather specialize in those things they can produce at the cheapest cost and buy the others in the marketplace—the advantage of specialization and trade. That’s how Smith came to urge nations to adopt the wisdom of households in the management of their production and consumption activities and to reject mercantilist restrictions on trade and opt for free trade instead.

We can apply the same wisdom of households to the question of paying the unemployed. Just as no household would expect that giving money to any of its members to spend would stimulate wealth creation for the household, so it is for the economy as a whole. An economy is little more than the collective activities of households. It is ultimately the aggregation of household production and consumption expenditures that is called gross domestic product, GDP.

We also can learn from the experience of Europe. Its greater “generosity” in unemployment compensation does not produce less unemployment and greater economic growth but higher levels of unemployment and relatively poorer economic growth than in the United States. Extending the period of unemployment insurance compensation only assures that the unemployment rate stays permanently higher than the 4 to 7 percent range within which it fluctuated over the last 20 years or so until 2009. Arguing about the ballooning deficit may help stop the extensions, but that really is a side issue. The real point is that paying people who are unemployed simply discourages them from seeking and/or accepting alternative job offers quickly. And such payments do not change total spending in the economy.

It is truly a pity that followers of Keynes’s mistaken understanding of how a monetary economy works now claim the relevance of his ideas to our current economic situation and are implementing some of his misconceived policies.

  • James Ahiakpor is a Professor of Economics at California State University, East Bay. He received his Ph.D. in economics from the University of Toronto and he has taught at Saint Mary's University and the University of Ghana.

    He is a member of the FEE Faculty Network