Thursday, June 30, 2011

The failure of Keynesian pump-priming

I've showed this before, but it's worthwhile repeating. The chart above makes a bold and striking statement: the more the government spends, in relation to the size of the economy, the higher the rate of unemployment; and the less the government spends, the lower the rate of unemployment. That's not the same as saying that rising government spending causes the unemployment rate to rise, since it's very true that rising unemployment forces the government to spend more (e.g., for unemployment benefits and other assistance to those losing their jobs), and rising unemployment goes hand in hand with a weaker economy, and that tends to push government spending higher in relation to GDP. So I want to be careful with the causation/correlation argument here.

But the experience of the past several years has been remarkable in that there is no question but that three years ago the government embarked on a major campaign to stimulate the economy via a massive increase in government spending. The big rise in spending as a % of GDP in the past three years was mostly driven by a forced increase in spending, and only partially by the fact that automatic stabilizers (e.g., unemployment insurance, food stamps) kick in as the economy weakens. And it is clear that this virtually unprecedented spending boost coincided with the biggest and fastest rise in the unemployment rate, and the deepest recession and slowest recovery in many decades.

At the very least this is prima facie evidence that Keynesian pump priming doesn't work, and it's potentially strong evidence that a big dose of pump priming not only doesn't work, it makes things worse. Furthermore, it's evidence that a significant reduction in government spending as a % of GDP does not prevent a significant strengthening of the economy: consider the 1993-2000 period in the above chart, when both spending and the unemployment rate experienced significant declines.

Spending is the elephant in the living room, and it needs to be cut back sharply. Government spending doesn't add to demand, it wastes resources. When the government spends more than it takes in, that money has to come from somewhere. And when government spends money it does so much less efficiently than the private sector. Moreover, deficit-financed spending takes just as many resources out of the economy as tax-financed spending. The only difference between the two is that when the government borrows to finance its spending the private sector at least has the hope of recovering the money some day, whereas with higher tax rates there is no hope of recovery. Plus, higher tax rates impact future decisions adversely, since they reduce the after-tax rewards to saving and investing and thus reduce future living standards by depressing investment activity.

The debate in Washington over spending cuts vs. higher tax rates is extremely important to the future of the economy. This has nothing to do with partisanship, and everything to do with basic common sense and the facts presented in the chart above. Since more government spending has hurt the economy, less government spending should help the economy.

UPDATE: I can see from a number of comments that readers are not getting my point. As I noted above, there is of course a natural tendency for spending as a % of GDP to rise during recessions (automatic stabilizers kick in, increasing spending, while the recession reduces GDP), but what is unique about this recession and recovery is the huge increase in spending (e.g., TARP, ARRA, cash for clunkers, emergency unemployment benefits) that occurred. Without the additional "stimulus" spending, the blue line in the chart above would have increased to 21-22% of GDP, but the additional spending came on top of that. Clearly, an unprecedented amount of spending has done nothing to improve the health of the economy, and most likely has hurt it.

UPDATE: Cato's Chris Edwards has nice article explaining more in detail why federal spending doesn't work.


Benjamin said...

Love those Clinton years--and yes, there was GOP control of the Congress in those years.

I hope those do not become the "good old days."

I hope better days are ahead.

TradingStrategyLetter - Weekly Summary said...

You are one of the clearest thinking economists I've ever read. Nice work!

ClamPuddingPaddler said...

This chart is deceptive because you are comparing the unemployment rate to two different metrics at the same time: federal spending and GDP. It's a no-brainer that the unemployment rate rises and falls with the rate of growth in the economy, so when the economy is growing rapidly as in the 90's, the unemployment rate was low and federal spending as a % of GDP was also low--because GDP was high! To prove your point, you would need to compare the unemployment rate with actual federal spending and I doubt the lines would match so nicely.

Matt Busigin said...

It's clear that unemployment leads increase in government spending. Of course it does! The government gets less tax revenue, and now has to spend money on servicing them.

What you see is the functioning manifestation of counter-cyclical spending: spending is not constrained by revenue. This is why economic activity actually bottoms...

This chart doesn't suggest we should cut spending. It suggests that tax revenues fall when people lose their jobs.

Bill said...

Have not most of the banks paid back the TARP? I also think TARP helped stabilize the markets during the height of the crisis.