Reducing Real Output by Increasing Federal Spending

The historical evidence clearly shows that very little government spending is necessary for growing prosperity. From the founding of the United States until the early 1930s, the federal government’s budget averaged only around three percent of the nation’s GDP, which was about half the spending of state and local governments. The federal budget was not balanced every year, but revenues and expenditures were closely balanced over the whole time period. Federal spending and budget deficits increased during wars, but the resulting debt was largely paid off with peacetime budget surpluses. For 28 straight years after the Civil War, for example, the federal budget was in surplus, with the Civil War debt greatly reduced, though not completely eliminated, by 1893.

During most of these 28 years, the economy was expanding, unemployment was low, and real wages were increasing and, by the early 1900s, America had become the world’s richest nation. There were economic downturns beginning in 1873 and 1893, but the federal government did little to respond to them. The 1893 downturn caused a federal budget deficit, but the deficit was caused almost entirely by decreased tax revenues rather than increased federal spending. The recovery from these downturns occurred in response to market forces, with neither downturn lasting nearly as long as the Great Depression of the 1930s. This shows that while market economies experience occasional recessions, they can recover—and have recovered and continued growing—without the Keynesian prescription of increased government spending and budget deficits.

This does not mean that federal spending was irrelevant to our early economic success. Most of the federal budget in the 19th century went for such things as national defense, infrastructure, law enforcement, and establishing standards on weights and measures. This spending created a setting in which the power of private enterprise and entrepreneurship could produce wealth. The one big exception was post-Civil War veterans’ pensions, paid entirely to Union veterans. According to Jeffrey R. Hummel, veterans’ pensions “grew from 2 percent of all federal expenditures in 1866 to 29 percent in 1884.”1 But what the government did not do was just as important as what it did. It rarely used its police power to override the decisions that consumers and producers made in response to the information and incentives communicated through markets.

A Shift in Ideology

Few Americans in the 19th century thought that the government could improve the economy by spending more to create jobs. Rather, the prevailing view was that prosperity resulted from people keeping most of their earnings because their investments and spending would lead to the production of goods and services that consumers valued most. And even fewer thought government could increase economic growth by taking money from some and transferring it to others to increase aggregate demand.

However, ideological changes began taking place in the late 19th century with the Populists and, later, the Progressive view that with regulations and transfers, the federal government could improve on unregulated markets by stimulating more economic output and distributing it more “fairly.” By the 1930s, this view was sufficiently widespread to give political traction to the idea that more government spending and control over the economy could reverse the economic downturn that became the Great Depression.2 The result was that federal spending expanded, and its composition changed.

Politicians had always wanted to transfer income from the general public to favored groups (or voting blocs), and now they had an excuse to do so under the guise of stimulating economic growth. This was bad economics, but the changing ideological view had made it good politics. Taking a little more money from everyone to provide transfers (in the form of subsidies, make-work projects, and bailouts) to a relatively few creates costs so dispersed, disguised and delayed that they are hardly noticed. The benefits are less than the costs, but they are concentrated, readily appreciated, and easily taken credit for by politicians. Not surprisingly, federal spending started increasing. It was about four percent of GDP in 1930; 15 percent in 1950; 20.7 percent in 2008; and estimated to be 25 percent in fiscal year 2011. And the bulk of this spending growth has gone to transferring income from those who earned it to those who have sufficient political influence to take it. Unfortunately, transfer payments make the country poorer than it would otherwise be—as do general increases in federal spending, given the current spending levels.

Government Spending Reduces Real Output3

The first problem with government spending as a way of stimulating economic growth is the cost of raising a dollar through taxation. James Payne4 has estimated this cost at $0.65 per dollar in taxes that the federal government receives. This figure includes the excess burden of taxation; the costs taxpayers incur to comply with the federal tax code and to deal with the audits and other enforcement activities by the IRS; the costs taxpayers incur to avoid or reduce their tax payments; and the costs for funding the activities of the IRS and other federal agencies involved in administering and enforcing the tax code. Moreover, those transfers often subsidize wasteful activities—such as growing cotton in the desert, turning corn into ethanol, and producing so-called green energy in politically connected companies—that fail even with massive subsidies. Also, the opportunity for some to confiscate wealth produced by others, and the desire of others to prevent this confiscation, motivates political “rent seeking” (socially wasteful efforts to benefit one’s self at the expense of others by influencing political decisions) that dissipates resources that could have been used productively. Transfers also create incentives for people to substitute government-provided income for income earned through productive effort. And because federal transfers, and the many detailed regulations that invariably accompany them, shelter people against the setbacks imposed by market discipline, they prevent or delay the adjustments required for productive economic coordination.

But couldn’t economic productivity be increased by targeting federal spending on hiring the unemployed either directly to work for government or by subsidizing private firms to hire them? Such an approach makes sense only if it produces more value than it costs, and there are several reasons for doubting that it does. First, with the federal government spending well over 20 percent of GDP, and most of this spending reducing economic productivity (spending additional dollars creates less value than it costs), it is unlikely that there are many government jobs left in which additional workers would add to the net productivity of the economy.

Second, assuming that there are government jobs in which the right people could create more value than their opportunity costs, without reliable market prices and wages guiding political decisions, it is very unlikely that political authorities would identify those jobs and match them with the right workers. This would be a problem even if the information were available to place government workers in jobs where they would be most productive. Political influence is far more important than economic productivity when officials decide what government jobs to create and on how much to pay those who are hired. This political influence is also dominant when private firms are subsidized to reduce unemployment by hiring more workers. Those subsidies are more likely to go to firms in politically favored industries that have been generous campaign contributors. Also, workers hired for federally funded or assisted construction projects are required by the 1931 Davis-Bacon Act to be paid the prevailing union wage, which is invariably higher than the market wage.

Third, hiring the unemployed is not the same as hiring people who are unproductive. Spending time looking for a job in which one’s contribution is the greatest is a productive activity. Most of the unemployed could get a job quickly if they were willing to take a low enough salary, but it makes sense to pass up jobs as long as the cost of continued search (including a foregone salary) is expected to be more than offset by finding a more productive job. But when the government provides or subsidizes a low-productivity job that pays Davis-Bacon wages, many will cease their job searches, even though continuing to search is more productive than the government jobs are. And it should be noted that workers typically face less incentive to be productive in government jobs than in private-sector jobs.

Fourth, even if an effort is made to hire primarily unemployed workers, many of those actually hired in response to federal stimulus spending are already employed or would have been hired soon anyway. According to a September 2011 study by the Mercatus Center,5 only 42.1 percent of those hired by organizations receiving stimulus funds from the 2009 American Recovery and Reinvestment Act (ARRA) were unemployed when hired. The same study also reported that 35 percent of the interviewed firms that were required to pay the Davis-Bacon prevailing wage (which required paying as much as 30 percent more) agreed with the statement that they “would… have been able to hire more workers at lower wages” and another 17 percent were not sure. The result is that fewer workers are hired and less value is created for each dollar of the stimulus funds.

The Impotent Multiplier Effect

Despite all these facts, some argue that government spending to hire the unemployed for completely useless tasks and paying them more than they are worth is good for the economy. Their argument is based on the claim that the workers spend their incomes, which starts a cycle of spending that increases economic growth through a multiplier effect. After all, John Maynard Keynes used the multiplier effect as the basis for stating that increasing government spending to hire the unemployed to “dig holes in the ground” is better than not increasing spending.6 Furthermore, according to Keynesian theory, the multiplier effect is even stronger when the government spending increases the budget deficit.

Interesting stories can be told with the multiplier effect playing the lead role, and some clearly find these stories compelling. But the economic history of the late 19th century has no place in these stories for an obvious reason. For over a quarter of a century after 1865, except for the recession that began in 18737, economic growth was healthy, and yet the federal government was spending, on average, only about three percent of the GDP and running budget surpluses every year. More recent evidence against the multiplier effect comes from our post-World War II experience. From its wartime peak, in 1944, to 1948, the federal government cut spending by 75 percent. The result was an economic boom, despite Keynesian predictions that spending reductions of this magnitude would result in massive unemployment as millions were released from military duty and war-related civilian jobs. From September 1945 to December 1948, the unemployment rate averaged only 3.5 percent.8

The problem with the multiplier story is that people respond sensibly to government policy. They know that someone has to pay for government spending, even if it is financed by debt. More debt today means higher taxes in the future to pay for the mounting interest charges and to repay the principal. Of course, the government can default on at least some of the debt through inflation,9 but inflation is a tax, and taxes discourage productive activity. So, absent outright default, any benefit people receive from deficit spending not only is temporary, but also will have to be paid back one way or another. As Milton Friedman10 established, people spend far less out of temporary increases in their income, even increases that do not have to be paid back, than they do out of permanent increases. When people recognize that they will have to pay back the temporary increase, they are unlikely to spend much, if any, of it11. Furthermore, large increases in deficit spending create uncertainty about how the debt will be paid back, as well as how government expansion will affect the business climate. Such uncertainty has a negative effect on consumption and investment, with the greater negative effect being on investment.

Although consumer spending is lower because of the recent recession than it otherwise would have been, it is not as sensitive to economic uncertainty as business investment is. Indeed, consumers are spending more today than they were before the recession began. According to the National Income and Product Accounts from the U.S. Department of Commerce, the annual rate of consumer spending was $9.8 trillion in the first quarter of 2007 and $10.68 trillion in the second quarter of 2011.12 It is investment that has declined sharply. According to a report by Robert Higgs,13 the annual rate of net business investment dropped from $463 billion in the third quarter of 2007 to $144 billion in the fourth quarter of 2010. So, despite the common view that we have to stimulate consumption to revive the economy, the real problem is to reduce the economic uncertainty that is depressing the investment upon which our future productivity depends.

And this brings us back to the primary reason that federal spending isn’t stimulating economic growth by increasing aggregate demand. Effective aggregate demand is increased by productivity, not by a printing press or another round of quantitative easing. No matter how much money is created, or borrowed, to finance yet more federal spending and to hopefully increase aggregate demand, effective aggregate demand is always limited by how much has been, or will be, produced in response to that demand. No matter how much money you have, your demand means nothing without the production of goods and services worth demanding. Just ask a Zimbabwean.14 Only by increasing productivity can effective aggregate demand be increased, and the unfortunate reality is that increasing federal spending is decreasing both.