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Stimulating the Economy with Deficit Spending   January 8th, 2009
Not everyone agrees deficit spending is answer to recession       


More observations...

Ever since Obama was elected president the world has been waiting to get an idea of what his response would be to the current financial crisis. We had a pretty good idea that it would involve lots of government spending but we didn't really know how it would be structured or what it would be spent on. We still don't have the details but it's slowly getting clearer. And what we do know is that he's selling the idea of massive government spending.

Indeed it seems that Obama wants to follow in the footsteps of Franklin D. Roosevelt during the Great Depression: Borrow and spend our way out of the crisis.

The Justification for Deficit Spending

The theory goes that in a recession, which is a contraction in the gross domestic product caused by reduced spending, the government can "jump-start" the economy by borrowing and spending unusually large quantities of money. This generates a deficit but, according to the theory, the increased government purchases during a time of otherwise dismal demand will generate enough demand to require continued output from the private sector. This added demand will create jobs (or prevent them from being lost) and, over time, this will snowball into a recovery. Once the recovery is underway the government can reduce its own spending because the recovering private sector will be producing its own demand. This was one of the theories championed by economist John Keynes .

Proponents of this theory suggest that President Roosevelt's massive "New Deal" deficit spending is what allowed the economy to recover from the Great Depression in the 1930's.

The Truth About the Great Depression

While President Hoover is generally regarded as having done little in response to the stock market crash of 1929 , the truth is that Hoover's federal government spent more money every year from 1929 forward--in dollar amounts, spending as a percentage of GDP, and deficits/surpluses as a percentage of GDP . Despite that, GDP continued to decrease and unemployment continued to increase.

Even using data and explanations that support massive deficit spending as the solution to the Great Depression , it can be seen that in 1932 deficit spending was 4.1% of GDP and FDR's New Deal took the deficit to 4.6% in 1933--and we're supposed to believe that an extra 0.5% fixed the GDP problem? And, interestingly, even though the GDP generally started improving in 1934, unemployment remained amazingly high even after six years of increased deficit spending.

A correlation does not imply causation. That means that just because "B" happens after "A", it doesn't necessarily mean that "A" caused "B." For example, the housing crisis happened after I bought a house. That does not mean that my buying the house caused the housing crisis. Likewise, that the Great Depression ended after an increase in deficit spending does not mean the deficit spending necessarily caused it to end.

Of course, the GDP itself will be increased by the government spending money by definition. GDP is the sum of all goods and services in the economy so obviously that number will increase if the government is buying more goods and services. However, looking again at the data from the proponent's page , even after deficit spending for nine years, the unemployment rate was still at 17.2%--only moderately less than the peak unemployment of 24.9% six years earlier at the height of the depression.

While the GDP numbers may show the Great Depression as having lasted four years, clearly the citizens of this country were suffering great unemployment until World War II--even after nearly a decade of deficit spending. Unemployment continued to drop during World War II and, sure, deficit spending grew even more during that period. But are we to believe that what a decade of deficit spending couldn't fix, four years of deficit spending did? I don't think so.

Deficit Spending Not Working Today, Either

It should be mentioned that we've been practicing deficit/Keynesian spending since 1957 . For over 50 years the federal government has been borrowing and spending and creating an ever-larger national debt every single year.

During the last eight years the deficits of the federal government have been huge--and, with the exception of two years, have been growing. Recent deficits have been downright astronomical with a real deficit in fiscal year 2008 of over a trillion dollars. And even though the government has been increasing deficit/Keynesian spending, the economy (as measured by GDP) has been shrinking and unemployment has been rising.

The massive spending that Obama wishes to try with his stimulus package has already been tried for the last eight years. We've been spending more and more and losing ground, not gaining it. Democrats and conservatives have rightly been bemoaning this massive deficit spending under President Bush. But now, as we contemplate a CBO-predicted deficit of $1.2 trillion (which will probably turn out to be over $2 trillion if historic accuracy is any indicator) even without Obama's stimulus package, we're supposed to believe an additional trillion in deficit spending is going to fix the economy? We have a credit crisis in this country and the solution is that we haven't borrowed and spent enough?

And let us not forget that even if deficit spending was the solution to the Great Depression, the national debt at the beginning of the Great Depression was 16.34% of GDP . In 1940, after a decade of deficit spending and as the Great Depression was giving way to World War II, our national debt was still only 42.37%. Today, at the beginning of our crisis, our national debt ($10.6 trillion) is 73.6% of GDP ($14.4 trillion) . Our relative debt level before the current crisis is almost twice what our debt level was after the Great Depression! In the 1930's we weren't constrained by an already-overwhelming debt. Today, we are constrained by a massive pre-existing debt.

This comes back to the fact that even Keynes thought that deficit spending should be counter-cyclical with the business cycle: When the economy is contracting excessively, the government should try to stimulate it with deficit spending. When the economy is expanding, the government should try to moderate the growth with government surpluses (raising taxes or reducing government spending); this moderates the booming economy and also serves the purpose of paying off the debt that was generated from when the government was engaging in deficit spending. But we haven't done the "surplus" half of that. Even if we assume that Keynesian theory is correct, it is foolish to believe we can constantly engage in deficit spending and then engage in even bigger deficit spending during a recession--even Keynes did not suggest that.

Our government has been constantly charging daily expenses to its credit card... and when an economic crisis comes about, Obama's proposal is to charge even more to the credit card. And don't forget that in about a decade Social Security is expected to start running deficits--at that point there will be even more pressure on the federal government to service its existing debt and pay increasing amounts in Social Security benefits.

We have debt as far as the eye can see and the situation is not sustainable. It's certainly not helped by heaping on more debt.

The Solution Isn't More Debt

Looking back at the end of the Great Depression, what changed during the World War II years wasn't so much spending. It wasn't even necessarily the war. It was confidence; or, rather, a reduction in the lack of confidence. People stopped focusing on the bad news of the recession and started focusing on the single-minded goal of winning the war. Instead of focusing on the bad news of the economy (which had been pretty much continuous for a decade), people were focusing and were motivated to win a vital national goal that motivated them. And while I don't have newspapers from the 1930's or 1940's, I'll bet there was a massive shift from reporting bad economic news to reporting either good war-time/victory news... or bad news of military defeats that further inspired America to work even harder to win.

More recently the media in America has been predicting that we were in a recession--or were about to be in one--since at least 2005 , even when we were still experiencing growth . We Americans have been hearing predictions of bad economic news for nearly four years even though a recession only began, according to the experts, a year ago. Not surprisingly there are those that wonder whether or not the media actually inflames the economy with bad news; and 46% of Americans believe the media actually tries to make the economic news look worse than it is .

The economy is going to improve only when Americans are confident enough to start spending money. That's going to happen when one or more of the following happens:
  1. Time passes and eventually things pick up in spite of the bad news.
  2. Something happens that gets more attention than economic news for a prolonged period of time.
  3. The media stops hyping bad news.
Increased government spending won't accomplish any of the above. It'll just get us further in debt.

And we already have too much.

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