Spending Your Way to Contraction?

 | Mar 28, 2012 | 8:00 PM EDT
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If you were a policymaker looking to reduce unemployment, what would you do?

The answer we've heard has been to spend more and more money, borrowing from the future to (hopefully) regain output today. While we have seen the economy recover -- output is higher now than it was just prior to the Great Recession -- employment has not. The economy has been able to do more with 5% less people, as productivity gains have erased some of the need for hiring.  If we had a stronger recovery, we would have been able to rehire more people and absorb new entrants to the labor force, while those productivity gains would have given us better standards of living.

We've had quite a big effort of government involvement to make this a stronger recovery. During election season, we might view some arguments with skepticism. As we discuss these economic topics, note that I am addressing this as an economist who is looking at data objectively and without a political agenda.

Recent research by Valerie A. Ramey in "Government Spending and Private Activity," published by the National Bureau of Economic Research, comes down firmly on the side that government spending reduces private sector activity vs. what it would be otherwise and that government spending reduces unemployment mostly to the extent the government hires those workers itself.

Ramey's research looks back over the period just prior to World War II to the present, so it's not focused on just the current downturn.  Only one time period jumps out when government spending really seemed to have worked to meaningfully reduce unemployment and that was during WWII.  Then, very strong productivity gains may have benefited economic fundamentals and perhaps some of this was due to patriotism. This period followed the Great Depression and the war effort was largely credited for putting many people back to work.

But other than that time period, Ramey concludes that "(o)n balance government spending does not appear to stimulate private activity." She also finds that this is independent of any tax-rate changes on the spending multiplier. Previous arguments, particularly those of Christina Romer, who was previously Chairwoman of President Obama's Council of Economic Advisors, had vigorously made the call that the multiplier -- the ripple effects of government spending that expands overall activity by an even greater amount than the funds spent -- was sufficiently large enough to justify the spending. Some numbers that were used for the multiplier previously had been around 1.5 or so, meaning that a dollar in government spending would increase total economic output by $1.50.

Ramey's research debunks that notion. She determined that the multiplier is generally significantly less than one, meaning that a dollar in government spending reduces private activity by an even greater amount, which means that total economic activity would be less with the government spending than without. She also finds that government spending increases government payrolls, reducing unemployment, but doesn't push the private sector to hire.

Ramey avoids all policy considerations and the research is missing a crucial element, forcing one to hypothesize.

One point is that government spending essentially reallocates from either taxpayers who can afford to pay more taxes to those who cannot or from future taxpayers to the citizens of today. In that regard, it can add to uncertainty about future taxes and spending and lessen business investment and consumer confidence.

But I would make an exception for investments in technology, infrastructure and education. These can improve private sector productivity and enhance profits, outputs and our standards of living. The interstate highway system is a good example of where the government accomplished what the private sector might not have done.

Another big issue is simply cause and effect, or impulse-response, if you prefer that terminology. It is easy to simply assume that government spending is a cause, or an impulse, and that private sector economic activity is the effect, or response.  It's just not that simple. One possible consideration might be that the cause behind both the need for government spending and the lack of private sector activity are the same. In other words, private sector activity may go lacking not because of government spending, but because there are other pernicious forces at work in the economy. 

One also can't prove the counterfactual that during those periods of severe economic conditions whether or not private sector demand would have fallen by even more without government spending? The economy is complex and it is almost impossible to model every variable, much less do so accurately. But more government spending is probably not the answer.

Instead, we need a thoughtful approach and not heated political rhetoric going into election season. And not every good idea involves big sums of money.

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