The Economic Effects of Government Spending

The following is a short research paper I wrote in the Spring of 2009 for an macroeconomics class, shortly after Obama’s wild spending spree culminated in the (worthless) $787 billion stimulus package. Some parts may be somewhat out of date (for example, I note that Paul Krugman remained silent — now we can’t get him to shut up) and the links may no longer be active, but the general points remain.

In an economy that is continually being dubbed the worst since the Great Depression, it is difficult for anybody, especially government leaders, to sit idly by and hope that the market rights itself. As such, we have witnessed a series of unprecedented bills being passed that promise to spend taxpayers’ money like taxpayers’ money has never spent before. Of course, this requires a large (and mandatory) investment on behalf of the taxpayers, whether they like it or not.

As such, it is important for every single U.S. citizen to understand the effects of these alarmingly large spending sprees, and to decide for themselves if they believe the risk is worth it and continue to support the leaders who implement such spending plans. They must determine if we are witnessing the most masterfully crafted recovery program in history or the beginnings of a complete fiscal catastrophe the likes of which have never been seen in the United States (and, perhaps, the world). Since the passing of a $787 billion stimulus package, it is important for all of us to understand the economic effects of government spending.

As usual, the best way to understand the economic effects of an action is to study what has happened in the past. Government spending has played a pivotal role in U.S. economics (as well as U.S. politics, but that is a different matter entirely), especially in the last century. Typically, the method used to evaluate the government’s role in the economy is its percentage of Gross Domestic Product (GDP). The rise of government spending in the 1930s, 1960s, and 1970s failed to recover economic growth. Comparatively, when the government shrank by one-fifth the percentage of GDP in the 1980s, the U.S. experienced an economic expansion. During the late 1990s, when government spending dropped below 20 percent of GDP, unemployment dropped at a similar rate. A graph, provided by the American Spectator, shows the correlation of government spending to unemployment.

Gov't Spending Chart

As is made evident by the figure, an increase in government spending almost always led to an increase in unemployment, and a decrease in spending was followed by a decrease in unemployment.

The main reasoning behind enacting a stimulus plan is the assumption that doing so “injects” money into the economy. At first glance, this method seems sound and reasonable, but further probing reveals that it is a difficult position to defend, perhaps because its very assumption is unsound. So why exactly does government spending correlate so strongly with unemployment, and why doesn’t “injecting” more money into the economy stimulate growth?

Basically, there are three ways the government can gain money to use as stimulant: increasing taxes, borrowing from the public, and printing more money. The first seems like it would be successful in stimulating growth, but is in fact quite deceptive. Since the tax rate rises, the taxpayer gets to keep less of each dollar earned on investment, which creates a disincentive to save or work. This disincentive can lead to the unemployment previously discussed, and the overall loss of productivity is a hidden cost tied to an increase in taxes. Of course, this method can be beneficial in other ways, if the gain to those who receive the spending is higher than the harm inflicted on those who pay the higher taxes. But it cannot be expected to improve the economy as a whole, since it is merely a balanced trade-off that affects one group adversely while another group benefits.

The second method of gaining this money is to borrow from the public. This, however, relies on the fundamental assumption that the money coming from the public was not going to be spent on anything else, but was intended to be hoarded by these individuals. Typically, if these individuals had not purchased government securities, they would have instead purchased private securities, and so government spending results in the crowding out of private investment.

This results in an increase in the demand for loanable funds, which causes the interest rate to rise. This discourages private demand for these funds, since the government spending has replaced these funds as the primary source.

The third and final way to finance government is to create new money. After creating this new money, the government can either choose to retain the same spending policies or use the money for some alternative investment. If they retain the same spending policies, the increased demand for government securities would raise their prices and lower the rate of interest.

Government is much more likely to opt for the third choice, to create the money and spend it in the hopes that it will create more jobs and give the economy a kickstart. This can have numerous impacts, sometimes leading to a drop in unemployment. Almost always, however, it has been examined that even if the employment level rises, price levels will increase with it. After the price levels adjust, unemployment begins to rise and the economy is back in the exact same spot it started. Unless, of course, the government continued to increase the amount of money in the economy, which leads to a downward spiral of inflation.

Despite the massive amounts of evidence, both in theory and observation, that an increase in government spending does not cause economic growth, there are still proponents of increasing spending during times of economic recessions. Gauti Eggertsson, an economist with the New York Federal Reserve, suggests that in times of economic recession the government must focus on spending rather than cutting taxes. The main problem in times of recession, especially the one we are experiencing now, is the lack of adequate aggregate demand, which can be stimulated by government spending. If we were to cut taxes, we would be placing all our hopes on the slim possibility that consumers will spend the money saved by the cuts.

Eggertsson’s position is difficult to defend, because as it may look good in theory, it is impossible to say how consumers would respond to tax cuts during a recession. This is because no government in the history of governments has tried cutting taxes in the face of extremely low interest rates.

As we have considered the effects of an increase in government spending, it is easy to come to the conclusion that, under similar conditions, a decrease in government spending will have opposite effects. It seems counterintuitive to many politicians, as they tend to want to be seen doing something even if it causes economic decline.

However, government spending can increase future productivity growth and growth in the labor supply. This requires an increase in the amount of either human or material capital, and the government can create this by spending money on education, training, medical research, and infrastructure. As long as the government can spend its money more competently than individual firms and focus on those investments that promote growth in the future, rather than merely redistributing money during a recession in the name of a “stimulus” package, there should be an increase in economic growth. Unfortunately, government institutions have proven time and time again that they are either incapable or unwilling to spend the money competently, mostly due to goals being politically rather than economically oriented.

Naturally, we must ask ourselves how we should handle government spending in the future. How can we convince elected officials to focus on increasing capital growth? Whether this is done by means of spending or saving is difficult to determine, and apparently even those in Washington haven’t figure it out. Can we find an effective method to encourage economic growth (or climb out of recession)? This paper so far has suggested that an increase government spending is detrimental to economic growth, and for good reason. Very few articles or news sources offered differing opinions, and those that did could not provide any reasoning behind their argument. As such, it would be nice to finally find a solution to economic recessions that all politicians can agree on.

We should also take into consideration the possibility of lowering taxes during economic recessions. What are the risks involved in tax cuts during recessions, and are they worth the risk? Most economists agree that the best strategy is taking the road mostly taken without furthering risk to the economy. In this case, that would involve elevating spending, which seems counter-productive since there is so much overwhelming evidence against such methods.

One final question to consider before we move on: Are the short term benefits of increased government spending worth the long term defecits? Initially, the answer is no. But perhaps there are some small gains that can lead to larger gains. It’s rarely happened in the past (perhaps once during the Great Depression), but it also hasn’t been studied very closely.

In regard to offering a defense in avoiding government over-expenditures, it seems the past speaks volumes and provides an irrefutable defense in and of itself. A Google search that explicitly seeks arguments for multimillion-dollar bailouts, such as the one President Obama signed into law, are numerous but lack substance. They pour their hearts and souls into arguing in favor of doing so, droning on and on how the economy will right itself if the correct amount of money is poured into it, yet in no way attempt to offer logic behind their arguments. Even notable Nobel prize winning economist Paul Krugman seems to avoid the issue. Perhaps the reasoning is too complicated for the general public to understand, but at the moment the motives to defend such an irresponsible spending spree seem to be politically driven. When an elected official proposes to give money to the masses yet cannot (or will not) explain where the government is receiving this money, we should be questioning his or her judgment instead of believing the typical anti-capitalism drivel pouring out of the media on a daily basis.

In conclusion, excessive government spending leads to numerous detrimental side effects, including (but not limited to) increased price levels, increased interest rates, inflationary spirals, decreased employment levels, unnecessary monetary redistribution, and generally prolonged recessions. The overwhelming evidence, both theoretical and observed, suggests that an increase in government spending does nothing to stimulate the economy in times of recession. Typically, government can fund spending in one of three ways: tax increases, borrowing from the public, and printing more money. Each has differing consequences, and can result in short term economic growth, but typically result in a government deficit in the long run.

One final question to ask is where have all the economists been? If the evidence clearly points away from spending and instead managing money responsibly, have the economists chosen to remain silent? Or have they been silenced by the overwhelming, tiresome officials that perhaps seek to shut them down? It is difficult to say, but we can only hope that at some point our leaders will use common sense and learn how to spend within the country’s means, rather than frivolously tossing around taxpayers’ money as if it is as abundant as grains of sand.

References

Eggertsson, G. (2008, December). Can a tax cut deepen the recession? New York City, New York, United States of America: Federal Reserve Bank of New York.

Noyes, R. (2009, February 1). Debunking the Myth that Government Spending Stimulates the Economy. Retrieved April 23, 2009, from NewsBusters: http://newsbusters.org/blogs/rich-noyes/2009/02/01/debunking-myth-government-spending-stimulates-economy

Riedl, B. (2008, November 12). Why Government Spending Does Not Stimulate Economic Growth. Retrieved April 23, 2009, from The Heritage Foundation: http://www.heritage.org/research/budget/bg2208.cfm

Wesbury, B. (2009, February 6). Unemployment and Stimulus. Retrieved April 23, 2009, from The American Spectator: http://spectator.org/archives/2009/02/06/unemployment-and-spending

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4 thoughts on “The Economic Effects of Government Spending

  1. Well, some seem to believe that Adam Smith’s impact, driving the politicians away from managing the economy, wasn’t gladly received by them. They certainly received Keynes happily when he told them the opposite, right? And how many economists do you hear about these days who don’t favor government economic management?

    If you want your name in the media, government research grants, a government job in economics, I suspect that’s the crowd to join…

  2. Pingback: Harry Reid’s New Obamacare Failure Theory | shiftthink

  3. Pingback: Harry Reid’s Obamacare Failure Theory « The Conservative Citizen

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