When signs of economic weakness emerge, most economics experts are quick to embrace the ideas of John Maynard Keynes.

For most economists, the Keynesian remedy is always viewed with positive benefits — if in doubt just push more money and boost government spending to resolve any possible economic crisis.

In this way of thinking, economic activity is presented in terms of the circular flow of money. Spending by one individual becomes a part of the earnings of another individual, and spending by another individual becomes a part of the first individual's earnings.

So if for some reason people have become less confident about the future and have decided to reduce their spending this is going to weaken the circular flow of money. Once an individual spends less, this worsens the situation of some other individual, who in turn also cuts their spending.

Following this logic, in order to prevent a recession from getting out of hand, the government and the central bank should step in and lift government outlays and monetary pumping, thereby filling the shortfall in the private sector spending.

Once the circular monetary flow is re-established, things should go back to normal and sound economic growth is re-established, so it is held.

Can Government Really Grow an Economy?

The whole idea that the government can grow an economy originates from the Keynesian multiplier. On this way of thinking an increase in government outlays gives rise to the economy’s output by a multiple of the initial government increase.

An example will illustrate how initial spending by the government raises the overall output by a multiple of this spending. Let us assume that out of an additional dollar received individuals spend $0.9 and save $0.1. Also, let us assume that consumers have increased their expenditure by $100 million. Individuals now have more money to spend because of an increase in government outlays.

Because of this, retailers' revenue rises by $100 million. Retailers in response to this increase in their income consume 90% of the $100 million, (i.e., they raise expenditure on goods and services by $90 million). The recipients of these $90 million, in turn, spend 90% of the $90 million, (i.e., $81 million). Then the recipients of the $81 million spend 90% of this sum, which is $72.9 million and so on. Note that the key in this way of thinking is that expenditure by one person becomes the income of another person.

At each stage in the spending chain, people spend 90% of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10*$100 million) than it was before consumers had increased their initial expenditure by $100 million.

Observe that the more that is spent from the additional income the greater the multiplier will be and therefore the impact of the initial spending on overall output is larger.

For instance, if people change their habits and spend 95% from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80% and save 20% then the multiplier will fall to 5. All this implies that the less is saved the larger the impact of an increase in overall demand on overall output.

Following this way of thinking it is not surprising that most economists today are of the view that by means of fiscal and monetary stimulus it is possible to prevent the US economy falling into a recession. The popularizer of the magical power of the multiplier, John Maynard Keynes, wrote,

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.1

Increasing Government Spending Cannot Increase Real Wealth

Let us examine the effect of an increase in the government's demand on an economy's process of real wealth formation.

In an economy, which is comprised of a baker, a shoemaker, and a tomato grower, another individual enters the scene. This individual is an enforcer who is exercising his demand for goods by means of force. The baker, the shoemaker, and the farmer will be forced to part with their product in an exchange for nothing and this, in turn, will weaken the flow of production of final consumer goods.

As one can see, not only does the increase in government outlays not raise overall output by a positive multiple, but on the contrary, this leads to the weakening in the process of wealth generation in general.

By means of taxation or borrowings, the government forces producers to part with their products for government services i.e. for goods and services that are likely to be on a lower priority list of producers and this, in turn, weakens the production of wealth.

Not only does the increase in government outlays fail to raise overall output by a positive multiple, but on the contrary, this leads to the weakening in the process of wealth generation in general.

According to Mises,

…there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens' spending and investment to the full extent of its quantity.2

What Causes Recessions?

For most commentators, the occurrence of a recession is a result of unexpected events such as shocks that push the economy away from a trajectory of stable economic growth. Shocks weaken the economy (i.e. cause lower economic growth so it is held).

In contrast to this view, we suggest that as a rule, a recession emerges in response to a decline in the growth rate of money supply. Usually, this takes place in response to a tighter stance of the central bank. Various activities that sprang up on the back of the previous strong money growth rate (usually because of previous loose central bank monetary policy) come under pressure.

These activities cannot support themselves — they survive because of the support that the increase in money supply provides. The increase in money diverts to them real wealth from wealth generating activities. Consequently, this weakens these activities, (i.e. wealth-generating activities).

As a result of the tighter stance and a consequent fall in the growth rate of money, this undermines various nonproductive activities and this is what recession is all about.

Given that, nonproductive activities cannot support themselves since they are not profitable, once the growth rate of money supply declines, these activities begin to deteriorate. (A fall in the money growth rate means that the nonproductive activities access to various resources is curtailed).

Recession then is not about a weakening in economic activity as such but about the liquidations of various nonproductive activities that sprang up on the back of increases in money supply.

Obviously then, both aggressive fiscal and monetary policies, which will provide support to nonproductive activities, will re-start the weakening process of real wealth generation thereby weakening the prospects for a meaningful economic recovery. Hence, once an economy falls into a recession the government and the central bank should restrain themselves and do nothing.

As a result of the time lag from changes in money supply to changes in economic activity, a downtrend in the annual growth of US money supply (AMS) since 2011 has likely set in motion the liquidation of various bubble activities (see charts).

It is quite likely that the annual growth rate of US real GDP will come under pressure in the months ahead. Note, that this conclusion is not derived from a statistical correlation between the lagged annual growth rate of AMS and the real GDP growth rate as such but from theoretical reasoning.

The graphical display is for illustration purposes only. In our framework of thinking the theory explains the data (theory is not derived from the data as such).

In this framework of thinking, which is based on the ideas of Ludwig von Mises, fluctuations in the growth rate of money supply always set in motion the phenomenon of boom-bust cycle regardless of statistical correlation between the money supply growth rate and economic activity.

(Click on image to enlarge)

Summary and Conclusion

During an economic crisis, what is required is for the government and the central bank to do as little as possible. With less tampering, more real wealth remains with wealth generators, which allows them to facilitate further expansion in the pool of real wealth.

With a larger pool of wealth, it will be much easier to absorb various unemployed resources and eliminate the crisis. Aggressive monetary and fiscal policies will only hurt the process of wealth generation thereby making things much worse.

As long as the pool of real wealth is still growing, the government and the central bank could get away with the illusion that they can grow the economy. However, once the pool begins to stagnate or decline the illusion of successful government and central bank policies is shattered. 

• 1.J.M. Keynes. The General Theory of Employment, Interest and Money, Macmillan & Co. LTD 1964, p. 129.
• 2.Ludwig von Mises, Human Action, 3rd revised edition, Contemporary Books Inc, p. 744.