Why The Economy Sucks

The news on the economy continues to be bleak—while unemployment is down from nearly hitting double digits, it’s still stuck well above the historical average. GDP growth continues to be sluggish. Businesses are skittish about hiring, which only adds to the troubles. Despite the yearly promises from the Obama Administration about a “recovery summer” (this year’s theme: “third time’s the charm, right?”) this summer is not looking to have much more economic growth than past summers. To put it succinctly: this economy blows.

But why? What is it that’s keeping the economy in the doldrums?

President Obama has his answer: it’s all George W. Bush’s fault. And a plurality of Americans even agree with that. The problem with that theory is Bush hasn’t been President for almost four years and all the things that he did that were supposedly so terrible (Foreign wars! Tax cuts for the rich! Wasteful government spending!) have all been ratified by the Obama Administration.

They’re All Keynesians Now

The other theory popular on the Democratic side and advanced by people like New York Times columnist Paul Krugman is that what we really need is massive government spending – or what economists would call “Keynesian stimulus.”

Keynesianism is named (appropriately enough) for John Maynard Keynes, a British economist and one of the most crucial (if frequently wrong) economic minds of the 20th Century. While Keynesian economic theory is far more advanced than could be explained in a blog post (no less one that anyone would want to read), the sort of “dimestore Keynesianism” that’s popular among today’s Democrats involves the simple theory that government spending produces economic growth.

Here’s how that theory is supposed to work: it posits that the reason why the economy sucks is because of a lack of “aggregate demand.” What that means in more conventional terms is that people aren’t buying enough shiznit. And because people aren’t buying enough shiznit, factories that make said shiznit aren’t running and are laying people off, and the economy is swirling the toilet.

That sounds pretty convincing at first blush – the reason why the economy sucks is because a lack of demand. It’s simple, it’s intuitive, but as I’ll get to later, it’s also wrong.

But first let’s look to what the dimestore Keynesians think is the solution. And they say that if the problem is a lack of aggregate demand, let’s stimulate demand! We take all those unemployed workers and we put them to work on “shovel-ready” jobs. They work for 8 hours a day repairing infrastructure and the government gives them a paycheck for it. Then, they go out and spend that paycheck, which creates demand. Suddenly those people are buying shiznit again, and the shiznit factories are producing their shiznit again, and the economy restarts.

Again, on the surface this all makes sense – it’s a nice and simple description of the problem, it’s a nice and simple solution, and maybe it just might work.

But it doesn’t.

The Economy Is Turning Japanese

In fact, we know that demand stimulus doesn’t work. It’s been tried before. In the 1990s, Japan’s economy took a nosedive after a major financial crisis and a housing bubble. (Sound familiar?) So the Japanese government engaged in a massive orgy of spending. (Sound familiar again?—and I mean the spending part, not the “Japanese orgy” part…) And what was the result? The Japanese economy went into a “lost decade” in which economic growth stagnated.

In 2009, President Obama passed the American Reinvestment and Recovery Act that was supposed to have created thousands of “shovel-ready” jobs and get the economy moving again. Obviously, it didn’t. Instead, unemployment continued to increase at a much higher rate than predicted. Even President Obama was forced to admit that those “shovel-ready jobs” weren’t exactly “shovel ready.” The stimulus didn’t produce the kind of job growth or GDP growth that President Obama promised. But why?

On the surface, Keynesianism makes sense, if you want to get the economy moving, get people jobs and get them to spend money. But once you scratch the surface, it all falls apart. Reason explains why in discussing the Japanese stimulus efforts:

In an attempt to encourage growth, the Japanese embarked on a massive, multi-billion-yen infrastructure program. They built roads, bridges, and airports, all with the goal of creating jobs and reviving the economy. This didn’t work either.

During the 1990s, Japan passed 10 fiscal stimulus packages, focused largely on public works, totaling more than ¥120 trillion ($1.4 trillion in today’s dollars). When one construction plan failed to stimulate economic growth, another was tried. Those plans did not succeed in reviving the economy, but they did saddle the nation with a mountain of IOUs that helped postpone recovery for years. Including “off-budget” borrowing, Japan’s debt was estimated to exceed 200 percent of GDP in 2001.

Construction plans often set job growth targets but rarely focused on project prices. From 1992 to 1999, the Japanese government spent more than $500 billion (in today’s dollars) on public works projects. Yet the construction jobs were not long-term and did not lead to sustained economic growth. Public debt sky-rocketed, unemployment actually doubled from 2.3 percent to 5 percent, and the economy remained stagnant. As Gavan McCormack, a historian at Australian National University, noted in his 1996 book The Emptiness of Japanese Affluence, “The construction state is in some respects akin to the military-industrial complex in Cold War America (or the Soviet Union), sucking in the country’s wealth, consuming it inefficiently, growing like a cancer and bequeathing both fiscal crisis and environmental devastation.” The government failed to properly identify which projects should be pursued, ignoring demand signals that the private sector is better at recognizing and responding to.

Taking Keynes To The Woodshed

So we know that Keynesian stimulus didn’t work in Japan and it didn’t work here in 2009. The passage above gives us some reasons why. Stimulus spending doesn’t work because of the way government spends money. Government does not spend money based on an economic calculus, they spend it based on a political calculus. This difference is crucial to understanding why most attempts at government intervention in the economy fails.

In a normal market, goods and services are allocated based on price signals. How does the economy know what to produce and how much of it? It’s all based on prices: when there’s too little of something the price shoots up—suddenly it makes sense to produce more of it. Then when there’s too much, the prices fall again. Supply and demand will, under normal circumstances, find an equilibrium.

The problem with government spending is that it doesn’t follow the rules of supply and demand. If a powerful Senator from South Dakota says that we need a six-lane superhighway between Podunk and East Armpit, that Senator can have the political clout to make it happen. The problem with that is that suddenly the government is spending millions to build a six-lane superhighway that isn’t actually needed and won’t produce economic growth over the long term.

“But wait!,” the Keynesians say, “Doesn’t building that six-lane superhighway to Warehouse 13 mean that workers will be employed and then they’ll have money to spend, creating economic growth?” The answer is yes, you’ll be paying people, but you won’t get economic growth from it. Why? Because the only way the government has money to spend is taxation or borrowing—so for every dollar you spend on that six-lane superhighway, you have to either take a dollar from elsewhere or borrow it and pay it back with interest.

There’s also a phenomenon called “crowding out.” This article explains the “crowding out” effect of stimulus spending in some detail. The short version is that if you take a dollar from the private sector and devote it to public spending, that’s a dollar that the private sector doesn’t have to spend. In other words, the government isn’t doing anything new, it’s just taking spending that the private sector would have done and doing itself. The net economic impact is, to put it in highly technical terms, bupkis. And if you assume that government spending is less efficient than private spending—and you should for the reasons above—the net economic impact is negative.

“But wait!” say the Keynesians again, “What about the infamous Keynesian multiplier?” The Keynesian multiplier is the theory that $1 in government spending produces more than $1 in economic growth. And whenever you hear President Obama argue that the stimulus saved “3 million jobs” and the like, here’s how he arrived at that conclusion. He had the Congressional Budget Office (CBO) assume that certain government programs had Keynesian multipliers, and then calculate based on what was spent in stimulus funds. So if you assume that infrastructure spending produces $2 in growth for every $1 spent, magically the stimulus was a fantastic success.

But the Keynesian multiplier is a myth: because of the inefficiencies in government spending and “crowding out,” the assumption that $1 in Keynesian spending produces at least $2 in economic growth is a very bad assumption to make. More rigorous studies have said that the real Keynesian multiplier ranges from zero to just over 1—which supports the idea that stimulus doesn’t produce growth over the long term.

And here is the other problem: when you try to “stimulate demand” in this way, what happens when the stimulus ends? The only thing propping up that artificial demand was government spending—and once the government spending ends, so does the stimulus. The conventional Keynesian theory is that the economy would come back, and once it did the government could retract the stimulus payments. But as Japan found out, that never happens. Stimulus becomes a vicious circle because once the stimulus ends the economy takes a nosedive—which just produces the argument that we need more stimulus to fix it. And indeed, you have Paul Krugman making the argument that we need more stimulus to get the economy moving, and if all else fails maybe we can hope for an alien invasion to get it. Someone has watched Watchmen one too many times.

The Myth Of Austerity

But the dimestore Keynesians have one more argument up their sleeves: they say that lowering government spending certainly won’t work, and will make things worse. They look to Europe, where they argue that the EU’s austerity has caused even more problems for the Eurozone. If Europe has been cutting government spending and Europe is now an economic basketcase, doesn’t that mean that fiscal austerity is a bad idea?

There are two problems with that argument: first, European governments really haven’t slashed spending as Krugman intimates they have. Except for Greece (which had little choice), most European countries have only slowed the rate of spending growth rather than cutting spending. That’s hardly “austerity” any more than only getting a 2% raise is a “pay cut.”

Second, Europe did something else that would depress economic growth—they raised taxes. European countries raised income taxes, their Value Added Taxes (VATs), and taxes on business. And sure enough, raising taxes when businesses and consumers are already feeling the pain of a recession is not a smart idea in the slightest. But the dimestore Keynesians propose doing the same thing: increasing government spending and raising taxes to pay for it. What Europe shows is not that austerity is a bad idea, it’s that government spending and tax increases are. What Krugman is doing is applying exactly the opposite message than what Europe is telling us. And the old saying goes, those who fail to learn from history are condemned to repeat it.

So, How Do We Fix This Mess?

So far I’ve been painting a pretty bleak picture: we can’t use government spending to get us out of this mess. The preferred Keynesian solution of raising taxes to stimulate aggregate demand won’t work because government spending doesn’t produce lasting economic growth. So, what can we do to get out of this hole?

Ultimately, what we need is to encourage economic growth in the private sector. But that’s not something that can be done with government policy—other than a policy of getting the hell out of the way. Government can offer tax credits for R&D and the like, but even that is an example of government picking winners and losers, which doesn’t have a particularly sterling record.

The most important thing is for the government to get its fiscal house in order. We can’t grow the economy with a huge amount of public debt hanging over our heads. We need to cut spending in real terms, not just slow the rate of increase. We need to pay down our national debt, not add to it. If we want to get more revenue into the hands of the government we need to increase growth rather than taxes. Has this been done before? Yes—and quite successfully. But that is a post for another day…