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John C. Goodman / Jan. 19, 2013

Can We Spend Ourselves from Recession to Prosperity?

Why is the recovery from the Great Recession so slow?

Why is the recovery from the Great Recession so slow?

Mounting evidence suggests there are two reasons: (1) We are discouraging employers from hiring and (2) we are discouraging the unemployed from seeking work.

Public policy uncertainty has been shown to be a major cause of employer reluctance to hire new employees, and the Obama administration has made the business community about as uncertain as they can be with ObamaCare, the Dodd/Frank financial regulation and more recently with its bizarre and totally unclear position on tax rates. At the same time we have greatly expanded the rewards for not working – so much so that University of Chicago economist Casey Mulligan estimates that half of the employment we are experiencing is because we are paying people not to work.

Yet there is another point of view. It’s old line Keynesian economics. A few years ago, most economists regarded this approach as a relic of the past. But the usual circumstances of our economic plight have given Keynesianism a breath of new life.

The Keynesians believe that our problems persist not because government is spending too much money, but because it is spending too little. And that’s despite the fact that the federal government is spending $1 for every 60 cents it raises in taxes. As Paul Krugman (the most prominent apostle) explained in The New York Times the other day, the burst of the housing bubble has caused ordinary people to retrench and pay down debt. This reduction in spending by the private sector must be offset by increased spending by the government.

Increased government spending on what? Most of the time, Krugman implies that it doesn’t matter. Certainly that’s what many Keynesians believe. Any spending is good. Really? Paying one group of workers to dig a hole and another to fill them back up would be good for the economy?

Not so fast says Kevin Murphy at the University of Chicago. Remember, in order for the government to spend money it doesn’t have, it must first borrow. The money it borrows must be paid back. In order for all this to have a positive effect, we must answer four questions:

  1. What is the value of the goods and services produced by the new government stimulus spending?

  2. What is the cost in terms of the lost output if some of the new spending simply attracts already employed workers from other productive jobs?

  3. What is the value of the loss of leisure time if some of the new spending results in the employment of previously idle resources?

  4. What is the social cost of raising taxes in the future to pay back the money the government borrows to fund the stimulus spending?

In order for stimulus spending to have a positive effect, our answer to (1) must be greater than our answers to (2), (3) and (4). Professor Murphy says that is unlikely to be the case. Government spending in general tends to be wasteful. Stimulus spending in particular tends to fund pork barrel projects that Congress has been previously resisting. Also, any new project tends to attract the most productive workers and those tend to be workers who are already working at some other job. Those who are idle are the ones that are most likely to put a high value on their idleness – something that lessens the social value of their new employment.

Finally, what is the real cost of raising taxes to repay the money we borrowed? Murphy says that when everything is considered, the social cost of $1 of taxes is about 80 cents. That 80 cents consists of the real resources people use to evade and avoid the tax plus the misallocation of resources that is cause by taxation.

The Congressional Budget Office (CBO) appears to agree with Murphy. Although the CBO doesn’t try to measure all the costs that Murphy says are relevant, the agency estimates that the long term benefit of the 2009 stimulus measure is negative. The measure did produce a short term increase in economic activity, says the CBO. But after 2016, GDP will be lower than it would have been with no stimulus at all.

Krugman remains unfazed. Of mainstream economists, he writes:

I and others have watched, with amazement and horror, the emergence of a consensus in policy circles in favor of immediate fiscal austerity. That is, somehow it has become conventional wisdom that now is the time to slash spending, despite the fact that the world’s major economies remain deeply depressed.

This conventional wisdom isn’t based on either evidence or careful analysis. Instead, it rests on what we might charitably call sheer speculation, and less charitably call figments of the policy elite’s imagination…

Despite this tirade, economist Robert Murphy reviews the scholarly literature and finds that the empirical evidence supports the mainstream view, not the Krugman view. Canada, for example is a country that has followed “austerity” policies with notable success. Add to that the recent experience of Ireland, the Netherlands and Finland. What about contrary evidence? Are there any examples of countries that have spent their way to prosperity? The usual example is the Great Depression, but even that episode is in doubt. As one Nobel Laureate economist wrote in 1998:

The point here is that the end of the Depression – which is the usual, indeed perhaps the sole, motivating example for the view that a one-time fiscal stimulus can produce sustained recovery, does not actually appear to fit the story line too well…

The economist who wrote that was Paul Krugman.

Lloyd Bentsen, IV helped with this editorial. I thank David Henderson for pointing to Robert Murphy’s article.

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