Karthik Reddy

“The Great American Boondoggle: Keynesian Spending Might Be Back, but It Still Doesn’t Work”

January, 2010 Print Edition

Seated in front of a row of large American flags at an economic forum in Denver on February 17, President Obama followed in the footsteps of his predecessor and signed the “American Recovery and Reinvestment Act of 2009” into law.  Obama intended the $787 billion bill to create some 3.6 million jobs, prevent the unemployment rate from climbing past 8%, and set the United States on the path to recovery.  Obama assured the Denver crowd that the massive fiscal stimulus would mark the “beginning of the end” of the financial crisis.

Nearly one year later, the rosy picture that Obama painted has yet to materialize.  The nationwide unemployment rate has climbed to 10%, consumer spending remains low, and foreclosure filings have continued to rise. Obama did, however, correctly estimate the magnitude of his economic plan; new government spending in 2009 exceeded new spending authorized at the height of President Franklin Roosevelt’s New Deal, both as a percentage and in real dollars.

The failure of the stimulus package was predictable in light of American economic history: contrary to popular belief, fiscal stimulus has never been able to substantially reduce the intensity or length of recessions or depressions.  The lack of effectiveness of the New Deal is an example of the impotence of fiscal stimulus.  Economist Christina Romer authored a 1992 paper in the Journal of Economic History that argued that New Deal spending had little connection with GDP growth prior to World War II.

The acceptance of this thesis has prompted some on the left to suggest that Roosevelt and his economic team failed because they did not spend enough.  The left suggests that World War II military spending jumpstarted the American economy and succeeded where the smaller New Deal failed.  Despite the simplicity and attractiveness of this story, empirical research has raised doubts about the role of World War II spending.  Economist Robert Higgs asserts that the economy was well on the way to recovery by 1940.  By 1941, however, the economic recovery stalled due to the diversion of resources to the military for the war effort.  He writes that the transition to the war economy drastically reduced unemployment primarily because of the coercive force of the military draft, and observes that real private consumption during the war declined in the United States. Furthermore, the stock market in 1944 had a real value less than the stock market in 1939.  The movement away from a command economy to a freer, more capitalistic market in 1945 allowed for the post-war boom.  Though the centrally planned wartime economy accomplished the United States’ military goals and defeated fascism in Europe and Asia, it did not generate sustainable economic growth.

Our modern stimulus is no exception.  The Obama team estimated that every dollar of government money spent in fiscal stimulus would magically generate $1.60 in economic activity.  There is, however, evidence to doubt the existence of such a wonderful economic tool.

Critics contend that short-term stimulus will not induce businesses to increase their workforce or production, as they know that the stimulus is short-term and will expire.  Furthermore, government borrowing may “crowd out” private investment and redirect funds and resources to public projects that are less productive than value-creating private projects. Attempts at quantifying the true effect of fiscal stimulus have turned up data inconvenient for the Democrats: economists Susan Woodward and Robert Hall took data from increased government spending in World War II and the Korean War and found that every extra dollar the government spent generated an equal $1 in economic activity. Economist Robert Barro used World War II data to estimate that every $1 spent only generated 80 cents.  The work of Woodward, Hall, and Barro indicates problems with the Obama team’s optimism.

Instead of massive fiscal stimulus, the government could have encouraged long-term, sustainable growth led by the private sector by cutting marginal tax rates or eliminating the corporate tax.  Economist Jeffrey Miron has estimated that the latter would cost the government between $300 and $350 billion per year, but would spur economic growth over the long-term, lessening the budgetary impact.

The past inability of government spending to generate sustainable economic growth, combined with the failure of last year’s stimulus package, indicates that government spending is not a good way to stimulate growth.  As such, any proposal for a second stimulus should be met with fierce and unfailing opposition.