Wednesday, March 4, 2009

Will increasing government spending work?



Of all the discussion regarding where the economy and markets are headed and what policies will affect their directions, none is more well known or understood to be as simple as the debate regarding federal government spending. For the left, federal government spending will help us. For the right, it will hurt us.

The case on the left for increasing federal government spending

John Maynard Keynes simple model is that during times of economic booms, the government should save money, and during times of recession, the government should spend it. This should make economic cycles less volatile. Proponents point to the "New Deal" programs of FDR that were done during the 1930's: massive public works projects that put 'shovels to the ground.' The idea here is that when the private sector is not spending money, the government can 'forcibly' spend money. This should make recessions less severe, and prevent depressions.

The case on the right against federal government spending

Government spending 'crowds out' private investment, according to anti-Keynesian folks who typically line up on the right. Government gets money immediately in two ways: by taxing private individuals and corporations, or by borrowing against future taxes on private individuals and corporations. The more government taxes or borrows against future taxes, the less money individuals have to invest and spend. So basically there is a "Robbing Peter to Pay Paul" problem. Interestingly, these anti-Keynesians also point to FDR's New Deal as evidence that Keynesianism does not work, as there was massive federal spending throughout the 30's, unemployment still was above 20%.

The evidence provided by historical charts


In the chart on the left, the three biggest increases of federal government spending as a percentage of GDP correlate to WWI (1917-1919), FDR's New Deal (1931-1935), and WWII (1941-1945).


What got us out of high unemployment was the spending associated with WWII. Another way to look at this is that FDR's increase in government spending was not enough, and it took the increase in government spending associated with WWII to bring unemployment down.


This chart on the left maps the same as above, but for a smaller period of time. As can be seen, it was Clinton who brought government spending down with a mostly Republican congress.

Conclusion
Current levels (before stimulus) of government spending are not at historic highs, even by post war standards. That should give us room to spend and borrow. Surely, cutting spending now is not evidenced by the charts. In fact, the case could be made that we need MASSIVE federal spending in addition to what has been budgeted so far. Conversely, the best years of prosperity have come when we have decreased spending after a period of elevated spending. Interestingly, I suppose this makes the case for massive military involvement, like a new war. There is no theoretical argument that says a dollar spent on guns is better than a dollar spent on solar panels, for example, but this should breath new life into the Neocons who want to invade Iran.
Another point to consider is absolute levels of government spending as differentiated from the changed in government spending. Since today government spending as a percentage is bigger than it was in 1930, perhaps it is not necessary to increase by as much.
In short, I conclude the stimulus package will help overall. If it fails to deliver the results, it will be because it is too small, rather than too big. However, to get prosperity back, we will need to quickly reduce government spending in the future so as not to crowd out private spending and investment. Currently, interest rates are extremely low, although the standards for getting loans are much higher, both for individuals, and for corporations. So there is not much crowing out going on currently.

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