by MARYANN O. KEATING, Ph.D.

Imagine, if you will, a small island economy; you may call it Pennsylvania, Virginia or Indiana. Assume that the population of the island is steady with 100 residents, two born and two dying each year. Sixty residents are in their prime years, working at home or in town; the remaining inhabitants are disabled, children or elderly. Each year a certain amount of eggs, corn, fruits and vegetable enter the domestic island economy for a constant annual gross domestic product of 1 million dollars, of which 10 percent account for necessary imports which are funded by an equal amount of exports.

Now, suppose that $50,000 is injected into the island economy each year from the outside, gifted through a church, government agency or private remittances. After some time, it appears that gross domestic product has increased each year by $150,000 for a new equilibrium Gross Domestic Product (GDP) of $1,150,000. A simple multiplier of three times the initial $50,000 injection from the outside represents the value of the additional goods and services produced.

Is it plausible that an additional $50,000 in spending could bring forth $150,000 more eggs, corn and fruit, and vegetables? Yes, but only if land, machinery, plant, tools and labor, all previously underutilized, begin to produce more. Real investment in chickens is needed to produce eggs, and plowing plus planting produces corn. Workers create manufactured products, and entrepreneurs establish firms and assume responsibility for meeting payroll.

Harvey Golub’s article, “How the Recovery Went Wrong,” in the May 23 Wall Street Journal, states that there is little doubt that additional U.S. government spending since 2008 of $5 trillion in an economy with an annual GDP of about $15 trillion had a temporary stimulative effect. The problem is that the cumulative effect on growth is significantly worse that the 11 recoveries from 11 recessions in the past 60 years. Goods and services do not equal those produced previously, and the rate of increase in GDP is insufficient to gain footing on the U.S. growth path.

Mr. Golub argues that the stimulus money was not spent wisely, but used to expand government and reward failing or favored auto and power industries. Regulatory pressure, fear of increased taxes and mandated costs put increased burdens on economically active individuals and the private sector. Furthermore, the stimulus was funded by debt, much of it held externally by foreign individuals and governments, on which interest must be paid.

Monetary policy was also expansionary with the intention of encouraging investment and, probably, to reduce the amount of tax revenue needed to service the debt.  Because of low interest rates, savers and retiree income has declined and riskier nonproductive investment and consumption encouraged.

The American Recovery and Reinvestment Act (ARRA), enacted in February 2009, injected directly into the state budgets about $135 billion to $140 billion over a roughly two and a half year period. Most of this money was in the form of increased Medicaid funding and into a “State Fiscal Stabilization Fund.” In addition, H.R. 1586 — the August 2010 jobs bill — extended enhanced Medicaid funding for six months, through June 2011, and added another $10 billion to the State Fiscal Stabilization Fund. Federal non-defense discretionary spending flowed through state and local governments in the form of funding for education, health care, human services, law enforcement and other services that states and localities administer. Although this spending alleviated human distress and ameliorated the hemorrhaging of state government budgets, it failed, for the most part, in drawing forth production from unemployed resources. The word “job creation” is a misnomer, or merely an indicator, of a growing economy better utilizing its natural and human resources.

There is no magic bullet in economics. To increase the amount of goods and services consumed in the absence of a significant technological breakthrough, an area must either produce these items at home or purchase them abroad. However, if our hypothetical island economy chooses to borrow in order to consume more in the present, sooner or later it must produce real eggs, corn, computer software, fruits, vegetables, and other goods and services to finance or pay off debt. An effective stimulus depends on engaging existing resources to produce more output.

Maryann O. Keating, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation living in South Bend, is co-author of Microeconomics for Public Managers, Wiley/Blackwell, 2009.

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