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Government Spending is not Stimulus - Video Newsetter

By Dan Mitchell - Email Editor

Date : January 20, 2009

Dear Valued Reader,

Politicians and interest groups argue that government spending should be increased to boost a weak economy. But is this a good idea? Government is big now, and it would be a good idea to look at theory and evidence before giving politicians a blank check to make it even bigger.

 

Keynesian theory sounds good, and it would be nice if it made sense, but it has a rather glaring logical fallacy. It overlooks the fact that, in the real world, the government can’t inject money into the economy without first taking money out of the economy. In effect, it only looks at one-half of the equation since any money that the government puts in the economy’s right pocket is money that is first removed from the economy’s left pocket. There is no increase in what Keynesians refer to as aggregate demand. Keynesianism doesn’t boost national income, it merely redistributes it.

Some advocates of this theory get a bit more creative and say that Keynesianism works because it increases consumer spending rather than the money sitting idle. But money that is unspent by consumers does not sit idle. It winds up in the banking system someplace and is used to finance investment spending. So-called stimulus programs, at best, shift how national income is used so that more gets consumed rather than invested, but as noted earlier, there is no increase in national income.

The real-world evidence also confirms that Keynesianism is a failure. In his four years, Herbert Hoover was a poster-boy for statism. He increased taxes dramatically, including a boost in the top tax rate from 25 percent to 63 percent. He imposed harsh protectionist policies. He significantly increased intervention in private markets. Most important, at least from a Keynesian perspective, he boosted government spending by 47 percent in just four years. And he certainly had no problem financing that spending with debt. He entered office in 1929 when there was a surplus and he left office in 1933 with a deficit of 4.5 percent of GDP. So how did Hoover’s big-government Keynesian experiment work? Since growth went down and unemployment went up, he clearly was not a success.

Unfortunately, other than being a bit more reasonable on trade, Roosevelt followed the same approach. The top tax was boosted to 79 percent and government intervention became more pervasive. Government spending, of course, skyrocketed – rising by 106 percent between 1933 and 1940. This big-government approach didn’t work for Roosevelt any better than it did for Hoover. Unemployment remained very high throughout the 1930s and overall output did not get back to the 1929 level until World War II.

Other Keynesian episodes generated similarly dismal results, though fortunately never as bad as the Great Depression. Gerald Ford did a Keynesian stimulus focused on tax rebates in the mid-1970s. The economy did not improve. But why would it? After all, borrowing money from one group and redistributing it to another group does nothing to increase economic output. More recently, George W. Bush gave out so-called rebate checks in 2001 and 2008, yet both times there was no positive effect. He certainly was a big spender, but it just didn’t work.

The international evidence also shows the foolishness of Keynesianism. The clearest example may be Japan, which throughout the 1990s tried to use so-called stimulus packages to jump-start a stagnant economy. But the only thing that went up was Japan’s national debt, which more than doubled during the decade and now is far above even Italy when measured as a share of GDP. The economy, not surprisingly, remained in the dumps.

So if Keynesian spending doesn’t make sense from a theoretical perspective, and also fails every time it is tried in the real world, why do politicians keep trying the same approach? I suspect that politicians love to spend other people’s money, and Keynesianism is a convenient rationale.

Dan Mitchell

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