The belief that by spending
more, the federal government can revive the economy by increasing aggregate
demand is an example of the triumph of hope over experience. Many people excuse
the recent failures of such stimulus spending with the claim that the spending
simply wasn't large enough. This demand-side view is oblivious to the
supply-side reality that demanding more does no good unless more has been, or
will be, produced. The logic of this reality explains why trying to increase
aggregate demand through increased federal spending is not the key to
stimulating the economy. The problem is not that aggregate demand is
unimportant—it is very important. The problem is that increased real aggregate
demand is the result, not the cause, of an increasingly productive and
prosperous economy.
The historical evidence
clearly shows that very little government spending is necessary for growing
prosperity. From the founding of the United States until the early 1930s, the
federal government's budget averaged only around three percent of the nation's
GDP, which was about half the spending of state and local governments. The
federal budget was not balanced every year, but revenues and expenditures were
closely balanced over the whole time period. Federal spending and budget deficits
increased during wars, but the resulting debt was largely paid off with
peacetime budget surpluses. For 28 straight years after the Civil War, for
example, the federal budget was in surplus, with the Civil War debt greatly
reduced, though not completely eliminated, by 1893.
During most of these 28 years,
the economy was expanding, unemployment was low, and real wages were increasing
and, by the early 1900s, America had become the world's richest nation. There
were economic downturns beginning in 1873 and 1893, but the federal government
did little to respond to them. The 1893 downturn caused a federal budget
deficit, but the deficit was caused almost entirely by decreased tax revenues
rather than increased federal spending. The recovery from these downturns
occurred in response to market forces, with neither downturn lasting nearly as
long as the Great Depression of the 1930s. This shows that while market
economies experience occasional recessions, they can recover—and have recovered
and continued growing—without the Keynesian prescription of increased
government spending and budget deficits.
This does not mean that federal spending was irrelevant to our early economic success. Most of the federal budget in the 19th century went for such things as national defense, infrastructure, law enforcement, and establishing standards on weights and measures. This spending created a setting in which the power of private enterprise and entrepreneurship could produce wealth. The one big exception was post-Civil War veterans' pensions, paid entirely to Union veterans. According to Jeffrey R. Hummel, veterans' pensions "grew from 2 percent of all federal expenditures in 1866 to 29 percent in 1884." But what the government did not do was just as important as what it did. It rarely used its police power to override the decisions that consumers and producers made in response to the information and incentives communicated through markets.
A Shift in Ideology
Few Americans in the 19th
century thought that the government could improve the economy by spending more
to create jobs. Rather, the prevailing view was that prosperity resulted from
people keeping most of their earnings because their investments and spending
would lead to the production of goods and services that consumers valued most.
And even fewer thought government could increase economic growth by taking
money from some and transferring it to others to increase aggregate demand.
However, ideological changes
began taking place in the late 19th century with the Populists and, later, the
Progressive view that with regulations and transfers, the federal government
could improve on unregulated markets by stimulating more economic output and
distributing it more "fairly." By the 1930s, this view was sufficiently
widespread to give political traction to the idea that more government spending
and control over the economy could reverse the economic downturn that became
the Great Depression. The result was that federal spending expanded, and
its composition changed.
Politicians had always wanted
to transfer income from the general public to favored groups (or voting blocs),
and now they had an excuse to do so under the guise of stimulating economic
growth. This was bad economics, but the changing ideological view had made it good
politics. Taking a little more money from everyone to provide transfers (in the
form of subsidies, make-work projects, and bailouts) to a relatively few
creates costs so dispersed, disguised and delayed that they are hardly noticed.
The benefits are less than the costs, but they are concentrated, readily
appreciated, and easily taken credit for by politicians. Not surprisingly,
federal spending started increasing. It was about four percent of GDP in 1930;
15 percent in 1950; 20.7 percent in 2008; and estimated to be 25 percent in
fiscal year 2011. And the bulk of this spending growth has gone to transferring
income from those who earned it to those who have sufficient political
influence to take it. Unfortunately, transfer payments make the country poorer
than it would otherwise be—as do general increases in federal spending, given
the current spending levels.
Government Spending Reduces
Real Output
The first problem with
government spending as a way of stimulating economic growth is the cost of
raising a dollar through taxation. James Payne has estimated this cost at
$0.65 per dollar in taxes that the federal government receives. This figure includes
the excess burden of taxation; the costs taxpayers incur to comply with the
federal tax code and to deal with the audits and other enforcement activities
by the IRS; the costs taxpayers incur to avoid or reduce their tax payments;
and the costs for funding the activities of the IRS and other federal agencies
involved in administering and enforcing the tax code. Moreover, those transfers
often subsidize wasteful activities—such as growing cotton in the desert,
turning corn into ethanol, and producing so-called green energy in politically
connected companies—that fail even with massive subsidies. Also, the
opportunity for some to confiscate wealth produced by others, and the desire of
others to prevent this confiscation, motivates political "rent seeking"
(socially wasteful efforts to benefit one's self at the expense of others by
influencing political decisions) that dissipates resources that could have been
used productively. Transfers also create incentives for people to substitute
government-provided income for income earned through productive effort. And
because federal transfers, and the many detailed regulations that invariably
accompany them, shelter people against the setbacks imposed by market
discipline, they prevent or delay the adjustments required for productive
economic coordination.
But couldn't economic
productivity be increased by targeting federal spending on hiring the
unemployed either directly to work for government or by subsidizing private
firms to hire them? Such an approach makes sense only if it produces more value
than it costs, and there are several reasons for doubting that it does. First,
with the federal government spending well over 20 percent of GDP, and most of
this spending reducing economic productivity (spending additional dollars
creates less value than it costs), it is unlikely that there are many
government jobs left in which additional workers would add to the net
productivity of the economy.
Second, assuming that there
are government jobs in which the right people could create more value than
their opportunity costs, without reliable market prices and wages guiding
political decisions, it is very unlikely that political authorities would
identify those jobs and match them with the right workers. This would be a
problem even if the information were available to place government workers in
jobs where they would be most productive. Political influence is far more
important than economic productivity when officials decide what government jobs
to create and on how much to pay those who are hired. This political influence
is also dominant when private firms are subsidized to reduce unemployment by
hiring more workers. Those subsidies are more likely to go to firms in
politically favored industries that have been generous campaign contributors.
Also, workers hired for federally funded or assisted construction projects are
required by the 1931 Davis-Bacon Act to be paid the prevailing union wage,
which is invariably higher than the market wage.
Third, hiring the unemployed
is not the same as hiring people who are unproductive. Spending time looking
for a job in which one's contribution is the greatest is a productive activity.
Most of the unemployed could get a job quickly if they were willing to take a
low enough salary, but it makes sense to pass up jobs as long as the cost of
continued search (including a foregone salary) is expected to be more than
offset by finding a more productive job. But when the government provides or
subsidizes a low-productivity job that pays Davis-Bacon wages, many will cease
their job searches, even though continuing to search is more productive than
the government jobs are. And it should be noted that workers typically face
less incentive to be productive in government jobs than in private-sector jobs.
Fourth, even if an effort is
made to hire primarily unemployed workers, many of those actually hired in
response to federal stimulus spending are already employed or would have been
hired soon anyway. According to a September 2011 study by the Mercatus Center, only
42.1 percent of those hired by organizations receiving stimulus funds from the
2009 American Recovery and Reinvestment Act (ARRA) were unemployed when hired.
The same study also reported that 35 percent of the interviewed firms that were
required to pay the Davis-Bacon prevailing wage (which required paying as much
as 30 percent more) agreed with the statement that they "would... have
been able to hire more workers at lower wages" and another 17 percent were
not sure. The result is that fewer workers are hired and less value is created
for each dollar of the stimulus funds.
The Impotent Multiplier Effect
Despite all these facts, some
argue that government spending to hire the unemployed for completely useless
tasks and paying them more than they are worth is good for the economy. Their
argument is based on the claim that the workers spend their incomes, which
starts a cycle of spending that increases economic growth through a multiplier
effect. After all, John Maynard Keynes used the multiplier
effect as the basis for stating that increasing government spending to hire the
unemployed to "dig holes in the ground" is better than not increasing
spending. Furthermore, according to
Keynesian theory, the multiplier effect is even stronger when the government
spending increases the budget deficit.
Interesting stories can be
told with the multiplier effect playing the lead role, and some clearly find
these stories compelling. But the economic history of the late 19th century has
no place in these stories for an obvious reason. For over a quarter of a
century after 1865, except for the recession that began in 1873, economic
growth was healthy, and yet the federal government was spending, on average,
only about three percent of the GDP and running budget surpluses every year.
More recent evidence against the multiplier effect comes from our post-World
War II experience. From its wartime peak, in 1944, to 1948, the federal
government cut spending by 75 percent. The result was an economic boom, despite
Keynesian predictions that spending reductions of this magnitude would result
in massive unemployment as millions were released from military duty and
war-related civilian jobs. From September 1945 to December 1948, the
unemployment rate averaged only 3.5 percent.
The problem with the
multiplier story is that people respond sensibly to government policy. They
know that someone has to pay for government spending, even if it is financed by
debt. More debt today means higher taxes in the future to pay for the mounting
interest charges and to repay the principal. Of course, the government can
default on at least some of the debt through inflation, but inflation is a
tax, and taxes discourage productive activity. So, absent outright default, any
benefit people receive from deficit spending not only is temporary, but also
will have to be paid back one way or another. As Milton Friedman established, people
spend far less out of temporary increases in their income, even increases that
do not have to be paid back, than they do out of permanent increases. When
people recognize that they will have to pay back the temporary increase, they
are unlikely to spend much, if any, of it. Furthermore, large increases in
deficit spending create uncertainty about how the debt will be paid back, as
well as how government expansion will affect the business climate. Such
uncertainty has a negative effect on consumption and investment, with the
greater negative effect being on investment.
Although consumer spending is
lower because of the recent recession than it otherwise would have been, it is
not as sensitive to economic uncertainty as business investment is. Indeed,
consumers are spending more today than they were before the recession began.
According to the National Income and Product Accounts from the U.S. Department
of Commerce, the annual rate of consumer spending was $9.8 trillion in the
first quarter of 2007 and $10.68 trillion in the second quarter of
2011. It is investment that has declined sharply. According to a report by
Robert Higgs, the annual rate of net business investment dropped from $463
billion in the third quarter of 2007 to $144 billion in the fourth quarter of
2010. So, despite the common view that we have to stimulate consumption to
revive the economy, the real problem is to reduce the economic uncertainty that
is depressing the investment upon which our future productivity depends.
And this brings us back to the
primary reason that federal spending isn't stimulating economic growth by
increasing aggregate demand. Effective aggregate demand is increased by
productivity, not by a printing press or another round of quantitative easing.
No matter how much money is created, or borrowed, to finance yet more federal
spending and to hopefully increase aggregate demand, effective aggregate demand
is always limited by how much has been, or will be, produced in response to
that demand. No matter how much money you have, your demand means nothing
without the production of goods and services worth demanding. Just ask a
Zimbabwean. Only by increasing productivity can effective aggregate demand
be increased, and the unfortunate reality is that increasing federal spending
is decreasing both.
Footnotes
1. Jeffrey R. Hummel, Emancipating
Slaves, Enslaving Free Men: A History of the American Civil War, Chicago:
Open Court, 1996, p. 331.
2. For an excellent
discussion of this shift in ideology, and its consequences, see Robert
Higgs, Crisis and Leviathan: Critical Episodes in the Growth of
American Government (Oxford: Oxford University Press, 1987),
particularly Chapters 6-8.
3. The discussion in this
section covers some of the same points as a more-formal model in Kevin M.
Murphy, "Evaluating the Fiscal Stimulus" (January 16, 2009). Seehttp://faculty.chicagobooth.edu/brian.barry/igm/Evaluating_the_fiscal_stimulus.pdf (accessed October 2,
2011).
4. James L. Payne, The
Culture of Spending: Why Congress Lives Beyond Our Means (San
Francisco: ICS Press, 1991), p. 186.
5. Garrett Jones and David
M. Rothschild, "Did Stimulus Dollars Hire the Unemployed? Answers to
Questions about the American Recovery and Reinvestment Act," (Mercatus
Center working paper no. 11-34, September 2011).
6. See John Maynard
Keynes, The General Theory of Employment, Interest and Money (New
York: Harcourt, Brace and World, 1936), Chapter 16. Of course, Keynes thought
it would be even better to put the workers to productive use.
7. The National Bureau of
Economic Research claims that the 1873 depression lasted sixty-five months, but
modern economists are skeptical that it lasted that long. Joseph H. Davis,
"An Improved Annual Chronology of U.S. Business Cycles since the
1790s," Journal of Economic History 66(1) (March 2006),
revises the length of the 1873 depression to no longer than 24 months.
8. See David R. Henderson,
"The U.S. Postwar Miracle," (Mercatus Center, Nov. 2010). http://mercatus.org/publication/us-postwar-miracle.
9. But see Jeffrey R.
Hummel, "Why Default on U.S. Treasuries is Likely," Library of
Economics and Liberty (Liberty Fund: August 3, 2009) http://www.econlib.org/library/Columns/y2009/Hummeltbills.html for an argument that the
federal government has less to gain from inflation as a way of reducing the
value of its debt than it did in the past, and that an outright default is
likely.
10. Milton Friedman, Theory
of the Consumption Function (Princeton: Princeton University Press for
the National Bureau of Economic Research, 1957).
11. See Robert Barro,
"Are Government Bonds Net Wealth?" Journal of Political
Economy, Vol. 82, No. 6 (Nov.-Dec., 1974): 1095-1117.
12. See Table 2.3.5, Real
Personal Consumption Expenditures by Major Type of Product at http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1&acrdn=2 (Accessed September 29,
2011)
13. Robert Higgs,
"Private Business Net Investment Remains in a Deep Ditch," The
Beacon (Oakland: The Independent Institute, February 20, 2011). http://blog.independent.org/2011/02/20/private-business-net-investment-remains-in-a-deep-ditch/
14. In November of 2008,
inflation in Zimbabwe hit an estimated rate of over 79 billion percent per
month, or an annual inflation rate of over 89 sextrillion percent.
See http://www.cato.org/zimbabwe. Zimbabweans were
impoverished despite, or because of, going shopping with a pocket full of bank
notes, each with a face value of 10 million Zimbabwe dollars
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