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Wednesday, February 10, 2010

Will Government Borrowing End the Downturn?

Keynesians miss the point of capital.


There are many unfortunate legacies of Keynesian “economics,” too many to list in this brief column. However, I concentrate on two of them: the notions that recessions change economic laws and that government borrowing equates to business borrowing.

Both views are championed by Paul Krugman. In The Return of Depression Economics he declares there really is a “free lunch” when the economy implodes and government must open the money spigots to “find it.”

People who had macroeconomics in college or graduate school are familiar with the horizontal “aggregate supply curve” that eventually turns upward until it is vertical. The implications are that government can “stimulate” the economy through new spending, pushing the economy’s “equilibrium” toward “full employment.”

(True “full employment” is unattainable unless the government instigates at least some inflation, which gives the economy “traction.”)

Keynesians hold that in the early stages of a downturn, government spending has only positive effects, a belief based on the false notion that opportunity cost is nonexistent. To say that recessions repeal the Law of Opportunity Cost is like saying the presence of aircraft repeals the Law of Gravity. If a good or factor of production is scarce (that is, if it requires any input of a scarce resource or labor), then its use has an opportunity cost.

Confusion exists because during an economic downturn, certain factors and the goods they are used to create no longer are in demand because they are part of a pattern of malinvestment that occurred during the preceding boom. According to Keynesians, an injection of government spending or new money will put those idle factors back into employment– the Keynesian version of the “free lunch.”

Idle for a Reason

As Henry Hazlitt noted in his 1959 classic The Failure of the “New Economics,” these factors are idle for a reason — something the Keynesians ignore because they attribute the situation to a sudden fall in “aggregate demand.” Austrians, on the other hand, believe those factors are unemployed because of malinvestments commenced during the preceding unsustainable boom. In that view, injections of new money only expand the economic distortions instead of “stimulating” the economy.

Krugman champions the belief that government borrowing is a near-perfect substitute for business borrowing, declaring:

I keep trying to tell people this: the surge in government borrowing has been more than offset by a plunge in private borrowing, and we’re less dependent on foreign financing than we have been for a long time.

Krugman can make this claim with a straight face because, as a Keynesian, he believes that an economy is little more than an amorphous blob of homogeneous factors and consumer goods. So as long as someone stirs enough money into the pot, the result will be a viable economy. Thus he can claim that the nation’s unemployment rate is high because the government’s “stimulus” efforts were too stingy.

Businesses borrow for two reasons: capital development and to employ a line of credit to avoid cash-flow problems. Capital is important because it permits the production of more goods while using fewer resources, thus allowing new resources to be applied elsewhere.

Likewise, the main economic significance of capital is not in the new money being spent. Capital is significant because its application permits an economy to grow. When business borrowing is down, that means investment in new capital has fallen.

Thus to claim that government spending equates to business borrowing is to misunderstand the very fundamentals of an economy and economic growth. Massive government borrowing not only burdens the country with debt, but it also increases the economic distortions and ultimately makes the downturn worse.

Nor does it matter whether we “owe it to ourselves” or the Chinese. What matters is that this spate of colossal accumulation of government debt is an intolerable burden that stimulates nothing but the fortunes of the political classes.


  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.