Spending and growth

As a number of European countries find themselves in the midst of a severe financial crisis and the US budget deficit plumb new depths, some politicians are beginning to realize that rampant government spending must be brought under control. While stupefyingly obvious to many of us, moves to cut spending are being resisted by those on the left. Having been given the keys to the Ferrari, they nonetheless want to keep driving even though the gas tank is almost empty and the oil light indicator is on.

Of course, leftist politicians can't be so crass as to acknowledge that huge deficits are essential to their vision of an expanded welfare state, and instead must dress up the case for continued high spending with a veneer of respectability in the form of Keynesian clap-trap. Taking the foot off the federal gas pedal, they argue, will harm a nascent economic recovery, causing the US to slip back into recession.

Oh please.

Both from a theoretical and historical perspective there is little reason to think that high levels of government expenditures can generate anything more than an ephemeral "sugar rush"-type boost to growth. Theoretically, we know that government does not introduce new resources into an economy, it merely reorganizes existing ones, typically in a less efficient fashion. Every dollar spent by the government is a dollar removed from the private sector either through taxation or borrowing, which is then allocated through political considerations rather than according to market signals.

From a historical perspective, meanwhile, we know that:

• High levels of unemployment persisted throughout the 1930s despite vast increases in government spending.

• Unemployment levels plunged in the wake of the 1921 recession when the government elected for a passive response.

• The US economy boomed and unemployment was around 5 percent after the conclusion of World War II when public expenditures were pared back from $84 billion to $30 billion.

• The 1990s economic boom was preceded by a 1993 economic stimulus bill which was a mere $1.9 billion ($2.8 billion in 2009 dollars).

• A series of government debt-fueled spending packages in Japan during the 1990s failed to rescue that country's economy from a decade-long slump.

Returning to the theoretical angle, if government allocates money to less productive ends than the private sector, not only should stimulus spending fail to spark a sustainable economic recovery, it should actually worsen the economy's long-term prospects. According to this short paper, that is exactly what has been observed:

This view is conventional but vastly incorrect. First of all a large literature starting with Giavazzi and Pagano (1990) has shown that large fiscal adjustments can be expansionary. Recently Alesina and Ardagna (2010) have provided the latest piece of evidence on this issue showing that, indeed, fiscal adjustments based upon spending cuts are more successful (i.e. lead to more stable consolidations of the budget) and cause less contraction of the economy than tax increases. In fact more often than not spending cuts boost growth even in the very short run.

Want to grow the economy? Slash government spending.

Update: Related thoughts from Coyote Blog. I should have also mentioned that another problem with government spending is that not only does it allocate money less effectively than the private sector, it also introduces higher overhead costs, producing another drag on efficiency.