Wednesday, July 11, 2012

Purchases and Transfers are not the Same

Copyright, The New York Times Company

The stimulus effect of government spending depends very much on the composition of that spending on purchases and on transfer payments.

Government spending on military personnel and purchases of military equipment vary considerably over time and across different countries. As a result, a number of studies have tried to estimate the effects of military spending on employment and gross domestic product.

Prof. Robert Barro of Harvard has worked years on this topic, with his most recent estimates prepared with Charles Redlick in 2009. They find that military purchases reduce the size of the civilian economy, but the civilian reduction is less than the military expansion, so the net result is a larger economy.

Another way to look at it: some additional military resources come from the civilian business sector, but the rest comes from people and materials that would be not be engaged in the economy at all.



By the same logic, government spending on road building, scientific research and other projects could expand the economy, although in the process they might reduce the size of the private sector. Perhaps road building and scientific research would even expand the economy in the long term as they made labor and capital more productive.

However, government purchases are a minority of federal government spending. The rest consists largely of transfer payments and interest payments on the federal debt. For example, the federal government spent $3.9 trillion in calendar year 2011, of which $2.3 trillion was on transfer payments such as Social Security benefits, unemployment insurance and food stamps.

Bureau of Economic Analysis

At first glance, there would appear to be little economic difference between government purchases and transfer payments, because in both cases the government writes a check, so to speak. When the check goes to a person for helping to build a fighter plane or highway, it’s called a purchase; when the government writes a check to an unemployed person it’s called a transfer. In both cases, the government must tax or borrow to finance the payment.

However, the economic effects of purchases and transfers are quite different. Government checks written for purchases of equipment, roads and so on are payments contingent on work and production: the people cashing the checks received them by virtue of producing something the government values. Moreover, all people use the roads, schools, parks and other projects built by the government without any assessment of their financial worth.

In contrast, people cashing transfer checks are not required to produce anything in return – and, as with unemployment insurance, for example, receive them because they are not producing anything. People who produce too much are ineligible for such payments.

Economists have found that the government gets roughly what it pays for. When it pays people to produce, a number of people accept that offer, and the economy is larger as a result. When government pays people for not producing, a number of people, in effect, accept that offer by working or earning less, and the result is a smaller economy.

The American Recovery and Reinvestment Act included purchases and transfers (as well as so-called tax credits, which are another story, discussed in a previous post). The transfers served to shrink the economy, while the purchases may have pushed to expand it.

On balance, that is why many Americans had trouble seeing much net economic expansion produced by the act.

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