Reducing
Real Output by Increasing Federal Spending
by Dwight R.
Lee*
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.
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.
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.
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
