AEI Says Stimulus Measures Worsened Fiscal Crisis

The financial crisis and recession of 2008-2009 were countered in many countries with Keynesian-inspired stimulus policies with, among other measures, large increases in public spending. Along with falling tax revenues, a sizeable increase in public spending has produced a serious debt crisis, which has in turn led to lower economic growth and higher unemployment rates. Some explanations for the failure of Keynesian policy include the so-called crowding out effect, unproductive and inefficient government decisions, poor timing and growing public deficits and debt. By contrast, countries that have cut public expenditure, upheld fiscal policy frameworks for balanced budgets, emphasized tax cuts, and reformed the economy for competitiveness have fared better. This paper explores the crisis-response policies of major developed economies and argues that stimulative policy has intensified the financial crisis rather than solving it.

Introduction²

What generates economic growth? How should countries handle economic downturns? What is the appropriate role of government in economic management? These questions have been put sharply into focus during the past five years as the world has dealt with a serious financial crisis. In many countries, the crisis was met with a renewed emphasis on government as the primary driver of the economy, renewing a commitment to the policy ideas of John Maynard Keynes (Keynes 1936). Other countries have pursued contrasting policies of limiting public spending, budget balance, and supply-side growth reforms. Analyzing the differences in the results is important, as it portends many implications for our future prosperity.

As the financial crisis unfolded, general public cries to "do something" were frequent in most countries.³ Many claimed that governments needed to show action and to assert that they were in control. At first, actions were limited to keeping the financial system working after the near systemic heart attack and the fall of Lehman Brothers. The definition of "systemically important" businesses was quickly widened as the slippery slope of economic intervention ballooned (Thomson 2010). In some countries, recommendations for counter-cyclical spending led to increases in public expenditure over several years. Consequently, large scale increases in the size of government spending as a percentage of GDP have characterized the fiscal position of most Western nations since the peak of the crisis.

As a Member of Parliament, I have encountered the call "we must do something" numerous times. "We" usually refers to the government and "something" usually means to increase public spending. Questions of "what" and "when" often garner less attention, due to the seriousness of the situation and a general lack of understanding about fiscal policy in general. But as a former think tank research director, I believe strongly that economic policy must be founded on fact rather than hasty emotion. If we launch policies, we must know whether these policies will worsen or improve the situation. Fortunately, an ample body of literature and a large amount of data supply us with sensible and well-crafted policy options.

The choirs of calls for intervention did not just come from special interest groups, big government-politicians, or alarmist media. Many economists joined in the throng, such as prominent and influential analysts like Martin Wolf of the Financial Times (Wolf 2008) and Nobel Laureate Paul Krugman, columnist for the New York Times (Krugman 2009). Krugman, whose decorated academic history includes a discussion of how interest rates will one day be calculated for goods transported through space (Krugman 2010), even facetiously argued that the world should prepare for an inter-galactic war with aliens as an example of how large-scale spending can jumpstart an economy.⁴ Obviously, Krugman did not think that such a scenario was likely, but argued that it would lead to more public spending and thus an economic stimulus.

With several major economies deeply immersed in debt crises, it has become obvious that the global economic system is highly dysfunctional. The most prominent debt crisis, which engulfed mainland Europe starting in mid-2010, has grown to mammoth proportions, but significant debt burdens in the United States have grown to unprecedented levels as well (CBO 2012). Substantial uncertainty in these economies has hampered recovery and deepened the crisis (Ait-Sahalia et al 2011). Countries that bailed out financial institutions and corporations -- in the name of "stimulus" -- are now in danger of needing bailouts themselves. It seems a new crisis management strategy is unveiled each week for many governments; indeed, governments across southern Europe have recently turned control over to crisis managing technocrats like Mario Monti in Italy and Antonis Samaras in Greece in an effort to curb the turmoil.

Smaller economies have proven, with some effort, possible to bail out -- at least in the near term. China has succeeded in sustaining growth through a managed active process of asset purchases. These purchases have widened China's global influence, but they have come at a cost. With a meaningful slowdown hitting China in mid-2012, and problems maintaining price stability (Carvalho, Eusepi, and Grisse 2012), Chinese leaders are left with difficult decisions.

Bigger economies pose different challenges due in part to their large size. A country such as the United States faces two distinct challenges to further substantial stimulus. Firstly, the sheer size of the economy dictates that any large-scale stimulus package would run into the hundreds of billions of dollars (Kregel 2011). But secondly, and more importantly, growing federal debt is a real danger to the economy; should the United States government face funding concerns, it seems unlikely that any agency has the resources needed to bail it out.⁵

This matter of debt -- and debt crises -- has tended to be long, deep, and difficult. Debt expansion in economic downturns is exacerbated either by active decisions not to reform unsustainable systems, active decisions to spend and ignore deficits, or both. Economists often argue that, since governments can spend when consumers are unwilling and can borrow on more favorable terms than individuals, budget deficits are necessary evils to stimulate the economy in downturns.⁶

Country-to-country responses to the financial crisis varied widely. Not all countries pursued expansionary, Keynesian-style stimulus policy, and disputes arose between countries as a consequence of conflicting ideologies. An emblematic quarrel between German Chancellor Angela Merkel and US President Barrack Obama at a G20 Summit in 2009 centered on a major policy difference regarding stimulus or austerity. Germany, with its history of fiscal restraint, opposed massive stimulus while the US favored expansion. Thus far, the results have proved to be very different for the two countries. Germany has seen better growth than it had had for many years and is widely viewed as the safest investment in Europe. Meaningful increases in competitiveness, coupled with falling unemployment and limited deficits, have made Germany the most stable economic climate in the euro area. The US has experienced the opposite: debt and deficits have climbed and unemployment has remained intractably high.

The dramatic development of recent years, with the debt crisis and the policies leading to it, raises anew the classic conflict between Keynes and Hayek. In the real world, countries and policies are complex and no country entirely follows theoretical principles. Yet because countries' responses and results have differed substantially, new lessons and evidence about the impact of countercyclical Keynesian policy have become available. This new research sheds light on the old conflict of economic ideas. Recent events can provide new insight about the effects of different policies that will help clarify the debate on future fiscal decisions.

Growth, prosperity and crises

From year zero to the year 1800, living standards remained roughly the same throughout the world (Maddison 2007). New generations could be fairly certain that their lives would follow the path of their parents and grandparents. But in the 19th century, institutions changed and allowed for prosperity to grow. Rule of law was firmly established in the Western world, and free enterprise and free competition expanded greatly. Trade and credit were liberalized, empowering people with the freedom to change their lives as old restrictions crumbled. This contributed to new technologies that were used by entrepreneurs to create benefits for consumers.

By 1848, Western societies had already experienced a massive increase in prosperity and living standards. That year, Karl Marx and Friedrich Engels published the Communist Manifesto, which stated that capitalism ("the bourgeoisie") has:

 

Figure 1.

 

Real GDP per Capita in the Unites States -- 1850-2008

 

In 1990 International Geary-Khamis Dollars

 

 

 

A major criticism of capitalism -- apart from the issue of unequally shared fruits of success -- has been its claimed inherent instability. The above curve trends upwards, but there are also downturns of various sizes. Economic historians have attempted to find some patterns to the ups and downs, referring to them as long waves, short waves, or cycles, depending on the context (Alesina, Roubini, and Cohen 1997). Throughout the most recent crisis, a strong resurgence of a second corollary has typified economic historians. The most recent claim echoes Schumpeter's decades-old idea that instability will eventually lead to a final crisis so large that it will crash the free-market system once and for all (1942).

Without doubt, economic crises have many very serious social effects in addition to their financial cost. Incomes fall, unemployment rises, and social problems increase in visibility. In turn, elevated uncertainty and doubt might even pave the way for extremism, which may threaten democratic institutions. Unsurprisingly, economists in the early 1930s turned much of their attention to the issue of economic downturns, their causes, and their solutions in the wake of the 1929 crash.

John Maynard Keynes became the dominating voice in this crowd. He was both an academic and practicing economist who held posts both at Cambridge and in various leading capacities in the British government. After commenting widely on the Treaty of Versailles and post-World War I peace process, Keynes's main contribution came with his main work The General Theory of Employment, Interest and Money in 1936 where he shaped the idea of falling aggregate demand -- the sum of government spending, investment, consumption spending, and net exports -- as the main cause of economic downturns. Because falling consumer demand leads to falling aggregate demand, and falling aggregate demands leads to lower wages, falling consumer demand becomes a self-reinforcing cycle as falling incomes cause consumption to fall even further. Consequently, Keynes argued, counter-cyclical government spending would be the only way to break the downward spiral.

Until the 1930s, the fiscal role of government in the economy had been limited. Taxes and public spending in Western Europe and the United States had risen from about 12.0 percent of GDP in the year 1900 to 19.6 in 1920 (Tansy and Schuknect 2000). This increase in the size of government has been dwarfed by the 42.2 percent average today among advanced economies (IMF WEO). Following the crash of 1929, the recovery was slow and the recession turned into a depression, with prosperity falling for years and unemployment rising to very high levels. Searching for explanations for this crash and depression, economists adopted Keynes's model as the general theory for explaining a government's role in expanding the economy.

Keynes theorized that a fall in aggregate demand should be met by governments acting to increase demand in the economy by running budget deficits and spending money. Prior to the Depression, the general praxis of Western nations was to aim for a balanced national budget (Reinhart and Rogoff 2009). This ran counter to Keynes's assertion that governments should borrow money and provide it to those who would consume, with the goal of stimulating growth. However, massive programs such as the New Deal soon put his theory into practice. World War II furthered this trend of enormous government spending -- although in that case the spending was not intended for stimulus purposes. After the war, the centrally-planned war economy was largely dismantled, but expansionary fiscal policy was credited with ending the Depression; this meant that Keynesian deficit spending remained very popular.

But while Keynes believed public spending of 25 percent of GDP was the "maximum tolerable proportion" for government intervention, above which spending would become harmful, most countries soon passed that level (Tanzi and Schuknect 2000). Most countries continued to increase the size of government, centralizing economic decision-making and putting voluntary decisions in the markets aside. Keynes had also emphasized that countries that ran deficits in downturns should create surpluses in upturns (1936). However, by the 1970s, it became apparent that deficits and debts would continue to grow regardless of the economic climate. Government institutions did not possess the discipline to pay back in good times.

Despite Keynesian efforts to increase demand through government injections of purchasing power, economic development remained weak during the 1970s. Growth levels were low, but inflation rose sharply -- and the new term "stagflation" was invented to characterize a period in which inflation was rising and the economy was not growing substantially. Government spending increased substantially throughout the 1970s -- not because of the temporary stimulus proposed by Keynes but with permanent public programs and systems. Public choice research has attributed much of this growth to internal dynamics of politics and bureaucracy that induce expansion. In theory, Keynes believed in limited government with temporary stimulus. In practice, his ideas were used to permanently increase the size of government.

In the 1980s, however, government growth slowed. Significant research shows that as government size and tax rates reach a certain level, growth is seriously hampered, causing tax revenues to fall (Reinhart and Rogoff 2010). As a result, countries like the United Kingdom and the United States reversed course in the 1980s: Margaret Thatcher in the UK and Ronald Reagan in the US introduced monetary policies for low inflation and increased economic freedom. Many other countries followed suit by expanding economic freedom. The world economy became more globalised with increased trade and capital movements as behind-the-border reductions in regulation and taxation quickly pushed the international system towards further integration. This not only increased institutional competition for a sound business climate, but also drove liberalization even further forward (Bergsten 1996). As the Soviet Union and its centrally-planned economy collapsed, the notion of total government control as a generator of growth and prosperity disappeared in idea as well as in practice.⁷ Keynesian ideas about the government-run economy became unfashionable.

From the late 1980s, economic freedom increased throughout the world, between countries as well as within countries.⁸ With limited exceptions, growth remained high and individual incomes increased by an average of 50 percent during this quarter-century, even when adjusted for population growth (Maddison 2005). The Western world saw country after country reverse policy direction by decreasing tax rates, deregulating markets, selling state-owned enterprises and facilitating entrepreneurship. Focus was placed on micro-level reforms that improve supply, while vast government programs intended to artificially boost demand fell out of favor. Increased central bank independence combined with stable price targets represented a major step away from a monetary policy run by politicians and attempting to fine-tune the economy in a Keynesian-inspired fashion. These new policies produced positive results in terms of lower poverty, higher incomes and lower unemployment (Munkhammar 2007).

A selection of countries in the Western world that decreased the size of government during these decades substantially includes the United States, New Zealand, Sweden, Denmark Ireland and Slovakia. (Mitchell 2005). All of these nations experienced high economic growth rates afterwards, and the policies have not -- contrary to some fears -- produced adverse social results (Munkhammar 2005). Despite these obvious gains, the global financial crisis of 2008 triggered the return of Keynesian-inspired policies of increased size of government -- for several countries, but not all. What happened?

European public spending and its effects

As the financial crisis unfolded during 2008, governments became very active in attempting to make the financial markets work, especially after the fall of Lehman Brothers. Fear spread about the state of the economy, leading to a substantial reduction in lending -- an essential component for new entrepreneurial activity. Initially, many believed the problem was limited to the United States housing market, but it soon became obvious that the "toxic assets" had been spread to many countries through the interconnectedness of the global financial system (Dungey et al 2010).⁹ Rating agencies compounded the severity of the crisis by maintaining ratings of most everything at AAA status. Their incentives were clearly disrupted by the fact that their paying clients were the lenders, not the borrowers (Bar-Isaac and Shapiro 2011). To solve the crisis, governments reverted to typical Keynesian policies, including buying assets to taking over financial companies. The latter has historically proven to give the taxpayers their money back in the end, which might be considered a benefit.

The causes and the processes of the financial crisis have been described in detail by others (Norberg 2009). Two things are worth pointing out in this context: firstly, after the initial efforts to kick-start the financial system -- costly as they were to national budgets -- many countries soon went for even costlier general stimulus programs. Secondly, as voices criticized financial markets as "too free" and demanded new regulation, they overlooked that financial markets had never been as regulated as tightly as they were in 2008, and therefore missed that the creation of toxic assets was a direct consequence of regulations aimed at increasing home ownership among low-income households. The housing bubble was, as is clearly demonstrable, fueled by the policies of the Federal Reserve and the US government (Wallison 2011). Government-driven demand stimulus thus had a direct role in causing the financial crisis in the first place. Still, many countries launched additional government intervention in the form of stimulus policies.

In 2008 and 2009, the European Commission launched initiatives to co-ordinate crisis policies within the Union, notably the European Framework for Action, the de Lariosiere Report and the European Plan for Recovery.¹⁰ The European Union is not a federal country,and its union-level budget is still limited to about one percent of GDP. Fiscal policy is thus a matter for the 27 member states, though a number of EU guidelines and regulations regarding national budgets play a role in shaping fiscal policy. During the past decade, 24 of the 27 EU countries increased the size of government as a share of GDP by varying degrees. Most of these countries did so from 2007 on, during the financial crisis, as a typical response to crisis and recession. Part of this process is automatic. As tax revenues decrease and public spending remains on the same level or increases during a recession, the share of government spending as a percentage of the economy necessarily increases. Benefits, such as unemployment insurance, experience new strains from increased claimants. However, the growth in most countries' spending also reflects the degree to which stimulus policies were launched to meet the effects of the crisis. Sweden and the United Kingdom, for example, had similar debt levels before the financial crisis, but now government debt is twice as high in the UK as it is in Sweden.

 

Figure 2.

 

Development in Government Size in EU countries, 2000-2010

 

In Percent

 

 

 

As Figure 2 shows, only three EU countries -- Sweden, Slovakia and Bulgaria -- decreased the size of government over this decade. All others made increases, although they were very limited in some countries, like Germany. A portion of the increase is a direct effect of the crisis, as previously discussed, and some is an effect of stimulus policy. Increases started from different levels of government spending, and increases from a low level of public spending likely have different effects compared to increases from a high level. But in analyzing the effects of stimulus policy on the economy, it is the direction of policies that matters, and the very point of the policies is to have a stimulative economic effect regardless of starting point.

The European countries are different in terms of size, exposure to global markets, business structure, and institutions, implying that an analysis aimed at detailed understanding must study them country by country. Any effort to find general effects from similar policies in different countries has to search for common patterns and possibly causal effects, and grouping countries for this purpose can be appropriate. Below, the EU countries are compared for a variety of phenomena with data extracted from Eurostat, and countries represented by the numbers listed below:

 

Figure 3.

 

Public Expenditures vs. Budget Balances, EU Countries, 2000-2010

 

Percentage Change

 

 

 

 Belgium                 1                    Greece                 8

 

Figure 4.

 

Public Expenditures vs. Net Central Government

 

Debt, EU Countries, 2000-2010

 

Percentage Change

 

 

 

Countries that increased public expenditure thus not only had bigger budget deficits but also saw an increase in government debt as a direct consequence of growing deficits being financed, usually by accumulating debt. As discussed below, the level of debt is of substantial importance for many other economic indicators, and so it is necessary to point out that increased public spending does increase debt. The increase in public spending was not financed by increased revenue, and thus followed Keynesian recommendation.

Next, economic growth is the result of many factors and is affected by a great number of institutions and policies. It is always very difficult to isolate the effects of one single policy on the degree of economic growth. But if the very intention of a policy is economic growth, there must be attempts to evaluate whether that aim was reached by launching that policy. A substantial increase in unfinanced public spending -- with deficits and debt increasing -- must be weighed against its costs and benefits.

 

Figure 5.

 

Public Expenditures vs. GDP Per Capita, EU Countries, 2000-2010

 

Percentage Change

 

 

 

It is clear from the European experience that increased public spending has not generally correlated with higher economic growth. If there is any correlation, it is the opposite. The more countries increased their public expenditure, the lower economic growth tended to be. The countries that experienced the highest growth rates during the past decade have either decreased their public expenditure or increased it only modestly, while the countries with the lowest growth rates are the ones that increased the size of government the most.

Northern Europe has stood out as the part of Europe that has continued to focus on supply-side growth reforms and avoided big Keynesian stimulus. Germany has become the champion of austerity in core Europe. German reforms in the labor market -- cutting taxes and unemployment benefits, combined with competitiveness-enhancing wage setting that has held unit labor costs down -- has led it to be one of few countries with falling unemployment during the last years. German exports have also experienced strong growth. In Finland, growth has remained high -- and these are two countries that share the common currency euro, illustrating the importance of national growth reforms rather than monetary or fiscal stimulus. The diagram below shows how employment has developed in the EU, OECD and selected countries during the last five years; high-stimulus countries have not done well in promoting job growth.

 

Figure 6.

 

Employment Levels, 2006-2010

 

Percentage Change

 

 

 

Symbolizing Northern Europe as a whole, Sweden has performed well economically, with an average GDP growth over the past five years twice as high as the EU average and clearly above the OECD average. Public debt is lower than before the crisis and employment is higher than it was five years ago, a rise even slightly higher than that of Germany. According to the World Economic Forum, Sweden is now the third most competitive country in the world. Recent figures show that Sweden has decreased its public expenditure by ten percentage points relative to the economy over the last ten years. During the crisis, Sweden resisted cries to "spend more" and stuck to frameworks for fiscal stability and was the only EU country with a budget surplus -- however limited -- in both 2009 and 2010. Sweden had a large budget surplus before the crisis and it has substantial social insurance systems, which quickly reduced the surplus as the crisis unfolded. However, this sizeable social insurance net cushioned against a sharp decrease in consumption.¹¹

Keynesian stimulus policies as practiced in Europe have produced the opposite of their intended result. Lower growth, bigger public deficits, and high government debt have become intractable. Instead of contributing a solution to the economic recession, the stimulus policies have contributed to the current debt crisis. Countries that avoided the path of Keynesian expansion have fared much better.

The United States and stimulus

The financial crisis started in the United States, at a time when the country already had a budget deficit. Former Vice President Dick Cheney famously remarked that "deficits don't matter," but has lately claimed that more should have been done during his time in office to keep public spending restrained.¹² During the final months of the Bush presidency, Congress passed bipartisan measures to support the financial system through the so-called TARP program, and then followed up this support with subsidies towards the auto industry in 2009. On February 13, 2009, President Obama signed the American Recovery and Reinvestment Act, encompassing close to $800 billion of so-called stimulus measures designed to lower unemployment. The stimulus was divided in three main pieces of similar size: funding for new private contracts, grants and loans, tax benefits such as refundable tax credits and funds to entitlements such as unemployment insurance (recovery.gov 2009).

The Obama administration claimed that the act would "create or save" 3.5 million jobs over the next two years. It also predicted that unemployment would drop to 7.25 percent by the end of 2010 and that government would spend the money in a timely and temporary way, according to Keynesian theory. A report published by the Council of Economic Advisors and Office of the Vice President-Elect even claimed that "[m]ore than 90 percent of the jobs created are likely to be in the private sector." (Romer and Bernstein 2009)

Have these promises been fulfilled? The Council of Economic Advisors claims that between 2.4 and 3.6 million jobs have been saved as of the first quarter of 2011 by the American Recovery and Reinvestment Act (Council of Economic Advisors 2011). According to Council's estimates, the cost of job creation would range from $185,000 to $278,000 per job. However, the numbers of jobs created are highly theoretical since the Council does not base its job numbers on any true count of job creation, but rather on estimates of how job funding flows through the economy to create labor openings. As economist Veronique de Rugy has shown, real unemployment figures have remained much higher than the figures the Obama administration projected would follow the stimulus program (de Rugy 2011a).

According to de Rugy, several factors may explain why the American Recovery and Reinvestment Act did not live up to its promises. Firstly, spending went primarily to the public sector, not the private sector. The job creation or retention that did occur seems mostly to have occurred in the public sector, contrary to the claim that more than 90 percent would be in the private sector. Secondly, the spending was not timely, which is a necessary for stimulus to have an effect, as the goal of Keynesian policy is a short-term boost to the economy. For example, only 62 percent of the $45 billion in infrastructure money in the bill had been spent as of June 2011 (de Rugy 2011b).

Thirdly, spending was not temporary. In Keynesian models, stimulus should be a short-term measure, not a long-term increase in government spending. However, the stimulus spending in the US act has lingered. Two years after the initial stimulus, 95 percent of the spending increases remained in place. Fourthly, the stimulus has not been well-targeted. No correlation is found by de Rugy between states experiencing the highest unemployment at the time when American Recovery and Reinvestment Act was passed and how much stimulus funding each state received. Such analysis suggests that stimulus funds have not been allocated according to each state's level of economic distress, but rather according to other mechanisms (deRugy 2010). President Obama later pointed out "there's no such thing as shovel-ready projects" when it comes to public works, demonstrating that most funds went to projects in the medium or long-term rather than the short term (New York Times 2010). Indeed, this is why researchers suggest that tax cuts -- which keep resources in the private sector -- are more effective at stimulating the economy than spending increases (Alesina and Ardagna 2009).

Unemployment has remained high despite massive stimulus spending for a variety of reasons. A study conducted by Daniel Rothschild and Garett Jones has followed what happened at the organizations that received contracts funded by the American Recovery and Reinvestment Act utilizing survey data from over 1,300 managers and employees. On average,an organization that received stimulus funds equal to 10 percent of its annual revenue reported retaining or hiring workers equal to 5-6 percent of its workforce. In-person interviews indicate that part-time and temporary jobs played an important role in this phenomenon (Rothschild and Jones 2011).

Notably, hiring is not the same as net job creation. In the Rothschild and Jones survey, around half of the workers hired at organizations receiving aid from the American Recovery and Reinvestment Act were unemployed, outside of the labor market or entering the jobmarket via school, whilst the remaining half were hired from other organizations. The researchers note that the data "suggests just how hard it is for Keynesian job creation to work in a modern, experience-based economy: even in a weak economy, organizations hired the employed about as often as the unemployed" (Rothschild and Jones 2011).

One answer to these objections is that the stimulus was too small. Total government spending increased from approximately $4.5 trillion before the crisis to an inflation-adjusted $5.5 trillion per year after the crisis. Deficits increased by about $1 trillion per year. In 2010, more than a third of US federal spending was borrowed money. During 2009-2011, deficit spending has been $4 trillion above the deficit the U.S was already running before the crisis. This $4 trillion is the total amount of Keynesian stimulus added into the economy, including measures such as automatic stabilizers.

Stimulus policies, coupled with the economic crisis and the general spending increases, has lead to a sharp increase in federal non-defense spending. Spending has increased from a historical average of 15.6 percent of GDP to close to 20 percent of GDP. According to the Long Term Budget Outlook of the Congressional Budget Office and using the White House's own estimates, non-defense spending will remain at 19.6 percent in 2016, eight years after the onset of the 2008 economic crisis (Sanandaji 2011).

 

Figure 7.

 

Real GDP per Capita in the United States -- 1850-2008

 

In 1990 International Geary-Khamis Dollars

 

 

 

This increase in federal spending has produced a massive deficit, with net public debt increasing from below 43 percent of GDP in 2007 to nearly 75 percent in 2011. Further increases are expected to bring net debt to 81 percent in 2012. US spending policies have been much more expansive than in the average OECD nation, where public debt is projected to increase from 38 to 66 percent during the same period. However, these costly stimulus policies have not enabled growth rates in the US economy to be significantly stronger than the OECD average (OECD).

 

Figure 8.

 

Growth and Debt in the US and OECD

 

In Percentage

 

 

 

Annual grworth rates in Real GDP are on the right, and government debt as a percentage of GDP is on the left.

Figure 8 shows US debt increasing faster than the OECD average, but growth lagging behind OECD average. The US has thus had little gain from policies that led to a massive public debt growth but do not benefit the economy substantially in the short term. Perhaps this should have been expected, as shortly before the stimulus package was launched, the Congressional Budget Office projected a dour view for the economy. Although the report was optimistic that the stimulus would have a short-term effect on output and employment, it noted that in the long term the government spending would "crowd out" private spending, thus leading to lower GDP in 2019 than would have been the case without the stimulus. (Congressional Budget Office 2009)

The short-term gain in employment and output from the stimulus seems to have been limited at best, as the US economy has experienced considerably higher unemployment than projected by the Obama administration and has grown in roughly the same fashion as the average OECD nation.

Failed stimulus policies not surprising

There are several reasons why increases in government size might lead to lower economic growth rates rather than higher. Firstly, there is a cost borne by the economy in the shifting of resources from the private sector to the public sector in terms of borrowing. A second, related effect comes when the government spends that money and once again diverts resources to its own machinations rather than the private sector's more efficient ends. Unless the way the government spends the same money is economically more beneficial for society than otherwise would have been the case -- if spent by anyone else in society -- the replacing of private spending with government spending will result in lower social welfare and less wealth (Rothbard 1962).

Thirdly, a risk exists that government spending will bias the economy towards certain types of economic activity at the expense of other activities. This effect is particularly pernicious if government -- unintentionally or intentionally -- rewards unproductive behavior, which lowers the general level of productivity, and thus wealth, within an economy. This classic problem of economic central planning, which prevents governments from predicting where the new ideas, companies or jobs will grow, is exacerbated by expansionary fiscal policy. True wealth creation can only develop as part of a continuous process of trial and error among entrepreneurs, investors and consumers (Mises 1922). Finally, government spending in terms of providing services comes with a big risk that it is delivered less efficiently than would be the case if the service was delivered by competing actors in the market.

An important distinction in the debate about public policy regards the tradeoff between risk and uncertainty. As Frank Knight introduced in his classic Risk, Uncertainty and Profit, the burden imposed by elevated uncertainty makes investors more risk averse. The result is that less investment flows to profitable sectors of the economy, and lower economic growth and job growth ensues. Keynesian stimulus policy generally creates a substantial amount of economic uncertainty by muddying the waters in terms of tax structure, interest rates, and government transfers. In so doing, stimulus policies make it more difficult for new investment to take hold in economies, and economic growth suffers (Knight 1921). In fact, the increased uncertainty of growing debt burdens in the developed world has created a substantial and meaningful slowdown in part because of the inadequacy of forecasters to predict how debt burdens will affect the economy (Easterly 2011).

Government spending might thus be harmful for economic growth if deployed, as is likely, inefficiently. This has been the conclusion in a number of studies. As one IMF study concluded: "This tax-induced distortion in economic behavior results in a net efficiency loss to the whole economy, commonly referred to as the 'excess burden of taxation,' even if the government engages in exactly the same activities-and with the same degree of efficiency-as the private sector with the tax revenue so raised" (Tanzi and Zee 1997). A study from the Federal Reserve Bank of Dallas similarly pointed out: "[G]rowth in government stunts general economic growth. Increases in government spending or Taxes lead to persistent decreases in the rate of job growth" (Fu, Taylor, and Yucel 2003). A Quarterly Journal of Economics article claimed: "[T]he ratio of real government consumption expenditure to real GDP had a negative association with growth and investment" (Barro 1991). An OECD study calculated: "An increase of about one percentage point in the tax pressure -- e.g. two-thirds of what was observed over the past decade in the OECD sample -- could be associated with a direct reduction of about 0.3 percent in output per capita. If the investment effect is taken into account, the overall reduction would be about 0.6-0.7 percent" (Bassanini and Stefano Scarpetta 2005). According to a National Bureau of Economic Research paper in 1999 by Alesina et al concluded that the opposite effect is also possible to calculate: "A reduction by one percentage point in the ratio of primary spending over GDP leads to an increase in investment by 0.16 percentage points of GDP on impact, and a cumulative increase by 0.50 after two years and 0.80 percentage points of GDP after five years" (Alesina et al 1999) (Mitchell 2005).

Economists Magnus Henrekson and Andreas Bergh have added to the research on the correlation between public expenditure and growth, and they conclude from the vast literature that a ten percentage point difference in the level of public expenditure will change GDP growth by between 0.5 and 1 per cent annually. In their view, higher spending will lead to lower growth. Those concerned with social welfare would do well to realize this fact, since it takes 36 years for incomes to double with an annual growth at two per cent, but only 24 years with an annual growth at three per cent (Bergh and Henrekson 2010, 2012).

The so-called crowding out effect might explain much of the Keynesian failure. According to Keynesian theory, output in the economy expands as government spending increases. One possible reason why expansionary policies might fail in reality is that when government expands spending, private investment is crowded out by changes in the distribution of investment towards public expenditures. This is primarily the case when spending increases are financed through debt rather than increased taxes, in large part because individuals and businesses realize that the increased spending and debt have to be paid for in the future (Barro 1979). Additionally, an increased supply in government debt can lead to increases in interest rates, which also has a contractionary effect on private sector investment.

Another study focuses on how government spending and taxes have affected the economy during the period following the Second World War showing that, in accordance with Keynesian theory, increased government spending leads to higher output. However, the results also show that when government increases spending or increases taxes, there is a strong negative effect on investment spending (Blanchard and Perrotti 2002).

A newer study reaches similar conclusions using new methodology. The authors show that fiscal spending shocks appear to "significantly dampen corporate sector investment and employment activity."¹³ Summarizing their article, the authors write: "This retrenchment follows both Senate and House committee chair changes, occurs in large and small firms and within large and small states, and is most pronounced among geographically-concentrated firms" (Cohen, Coval and Malloy 2011).

Another study has examined the stimulus policies launched by the Obama administration in 2009, as well as two previous stimulus packages launched under the president George Bush in 2001 and 2008 respectively (Taylor 2011). The author notes that "the three American discretionary countercyclical stimulus packages of the 2000s had little if any direct impact on consumption or government purchases, and thus did not stimulate the economy as Keynesian models would predict." Taylor claims that the reason is that "[h]ouseholds largely saved the transfers and tax rebates. The federal government only increased purchases by a very small amount. State and local governments saved their stimulus grants and shifted expenditures from purchases toward transfers." He also concludes that counterfactual simulations show that a larger stimulus package "would not have increased government purchases or consumption by a larger amount" (Taylor 2011).

This conclusion is far from new, and follows a wide body of academic and anecdotal evidence. After the poor macroeconomic performance of the 1970s, critical policy evaluations of the Keynesian approach were performed by a number of researchers (Lucas and Sargent 1978; Gramlich 1978, 1979). Discretionary countercyclical spending policies fell out of style because they had failed to deliver expected results.

In 2002, a study examined the effect that discretionary fiscal policy had had on the US economy over time. The author concluded that stimulus policies appeared to become more active in recent years, but that "[c]onsiderable uncertainty remains about how large an impact discretionary fiscal policy has on output." Furthermore, "[t]here is little evidence that discretionary fiscal policy has played an important stabilization role during recent decades" (Auerbach 2002).

The questionable results of Keynesian economic policies seem to be a global pattern. A 2003 study looking at stimulus policies in 91 countries in the period after the Second World War found that "governments that use fiscal policy aggressively induce significant macroeconomic instability" (Fátas and Mihov 2003).

More recently, Japan has demonstrated the failure of stimulus policies. Since the early 1990s, Japanese politicians have attempted to jump start the economy by spending more and more. The economy has grown sluggishly, whilst Japan has amassed the largest debt amongst the industrialized nations at roughly twice the size of its GDP and has slipped from second to third place in total GDP (OECD 2011).

While the aims of stimulus policies tend to not be fulfilled, building up debt creates real problems. During the coming years and decades, both the US and Japan must deal with huge and growing deficits and debt. These debts, as well as the potential tax increases that might be enacted to counter them, may create a crowding out effect which can affect both output and employment.

Economists Kenneth Rogoff and Carmen Reinhart have recently shown that countries with high government debt-to-GDP ratios have weaker economic growth than other nations. Based on a dataset with 44 countries and spanning about 200 years, the authors demonstrate that nations with debt over 90 percent of GDP experience a drop in median GDP growth by one percent. The threshold for public debt is shown to be similar in advanced and emerging economies (Reinhart and Rogoff 2010). The persistence of the debt overhang's burden to the economy often continues for more than a decade following the initial contraction (Reinhart, Reinhart and Rogoff 2012).

The political process might affect the already uncertain economic time frames when attempting a stimulus. Vested interests battling to seize privileges from government have the potential to both bias spending programs and derail timely responses to crises. Determining the size and scope of a stimulus program is a difficult enough task as an academic exercise, with a variety of highly divided opinions among academic economists, and this task is made all the more challenging by the realities of the political process. The unpalatable political nature of most fiscal consolidation makes certain desirable economic moves politically difficult in most countries (Kanda 2011).

The potential growth effect of stimulus policy -- the size of the so-called "multiplier" -- is highly debated as well.¹⁴ An increase in public spending might increase growth in the short term, but many believe this effect to be very limited even before the possibility of rising deficits and debt is added to the discussion. The effects in the long term are even more difficult to predict, but estimates are generally more pessimistic. Jonathan Leightner, for instance, finds that the government multiplier for US spending drops steeply when spending increases significantly in any given quarter (2010). As Kanda (2011) found, the much-debated size of the multiplier also has an effect on the ability of politicians to reach compromise over consolidations or stimulus.

One main reason for this effect is that many forms of fiscal stimulus detract from productivity. Companies receiving government stimulus money in order to make it through a downturn have less incentive to improve productivity by innovating, rationalizing, finding new consumers or developing their products. Consequently, stimulus projects derail productivity gains and might hurt the real prosperity generators in society.

Additionally, high degrees of globalization and trade make the current global economy different than the economies Keynes had in mind. Much of what we consume is manufactured in other countries or parts of the world, and this dispersion of labor allows for a more efficient division of labor according to comparative advantage. Consumers benefit from lower prices and sharper competition that drives product development, and society in general benefits from a more comprehensive division of labor that allows us to specialize and produce more resourcefully. Many forms of government stimulus, by contrast, impede the furthering of the division of labor by either propping up unprofitable industries in the country to which stimulus is applied or by sending tax money to other countries through transfer mechanisms. Vernon Smith has shown that imports into the US have grown disproportionately since stimulus programs were launched because of this (Buchanan, Gjerstad and Smith 2011). The authors also predict that austerity will lead to lower imports and thus higher exports, through a weaker dollar, which implies that austerity would have a positive effect on jobs growth.

Policies that do stimulate the economy

As previously discussed, any stimulus policy would be difficult for a number of reasons. It is difficult to time it appropriately, both because it is difficult for analysts to assess where in a business cycle the economy actually is, and because it is difficult to find and launch appropriate spending projects on time. Because of this, many argue that monetary policy is the most neutral way to stimulate the economy, since it is generally directed towards all lines of investment, rather than towards specific businesses, companies, projects or individuals.¹⁵ Monetary policy has long been utilized to help stimulate growth alongside fiscal policy, but as interest rates reach zero or close to it, monetary policy becomes less effective. Additionally, monetary stimulus often gets the business cycle wrong; today, most analysts agree that maintaining artificially low interest rates for too long in 2001-2003 contributed to the US housing bubble that lead to the financial crisis (Munkhammar and Sanandaji 2008). For most crises, timing is just as problematic with monetary policy as fiscal policy. Finally, as the 1970s illustrated, an expansionary monetary policy always carries the risk of bringing on substantial increases in inflation without meaningful economic growth.

Before meaningful policy recommendations are made, it is important to keep in mind that the size of a government is not related to its ability to balance its own budget. Balanced budgets are equally possible in big governments as small government; budget deficits are equally likely in small governments as expansive states. Countries who increase the size of government will often find it more difficult to balance their budgets, but the size of government and the balance of a budget are not fully linked.

The fundamental policy question is how to achieve a growing economy and avoid the worst effects of downturns. Several countries have effectively handled sizeable crises through some effective mechanisms. One useful tool is fiscal policy frameworks. While it is important to seriously consider any major increases in public expenditures, achieving a budget in surplus or balance, or at least with only a limited deficit, is also important. The risk of ending up in a debt crisis with distrust from markets and high interest rates is lower if a country is running a surplus or balanced budget, which means that a balanced budget makes it easier for a country to achieve growth. And for budget policy to work, firm institutions with credible policy commitments to fiscal sustainability are important.

 

Figure 9.

 

Fiscal Framework Index vs. Government Debt as a Percentage of GDP

 

 

 

All countries also have so-called automatic stabilizers that produce automatic stimulus through tax policy, social insurance contributions, and public transfers to households in the event of a downturn. When people lose their jobs in a downturn, they get an unemployment benefit that acts as a cushion for their private income. This support for private incomes acts to maintain a certain level of demand in the economy, which in turn keeps the economy from spiraling downward. The automatic stabilizers are about one-third larger in the EU than in the US, and there is a substantial difference between northern and southern Europe. The south has much smaller stabilizers (Dolls and Fuest 2009). One could expect that countries with smaller automatic stabilizers would launch more discretionary stimulus programs, and indeed, the US and southern Europe have certainly done so compared to many other countries, but there is no general pattern (Dolls, Fuest and Peichl 2010). Automatic stabilizers have the advantages of being automatic, which means that timing is not an issue -- they start working when they are needed. Additionally, automatic stabilizers target the people most negatively affected by a downturn and thus mitigate the most serious social consequences. But automatic stabilizers are still a stimulus program, which means they also weaken the public finances, underlining the importance of running surpluses in good times and creating fiscal policy frameworks that make it difficult to engage in further expansions.

There is also research suggesting that cuts in public expenditure can lead to higher economic growth rates in the short run. This theory of expansionary fiscal consolidations was first described by Giavazzi and Pagano, but has since then been further developed by Harvard scholar Alberto Alesina who says:

Despite the effects from cuts in public expenditure being more growth-friendly than usually expected, it is very difficult for a country to cut its way out of a debt crisis. Economic growth must be the main objective for countries facing substantial fiscal challenges, and growth can be fostered through structural reforms that buttress sound fiscal policies and tax cuts. In many countries, particularly in Europe, productivity remains low because of government-run monopolies, heavy regulations, labor rigidity, protectionism and cartels (Trichet 2005). The OECD recommends that European economies open up service sectors, liberalize trade, launch mobility-enhancing labor market reforms, and balance national budgets (OECD 2012). Opening up markets, facilitating entrepreneurship and creating flexible markets may be politically difficult, since it challenges the status quo as well as many powerful special interests. The need for changes that increase productivity and growth is clear, and there is potential for quick results, as demonstrated by reform countries.¹⁶ The importance of structural reform for short-term growth cannot be underestimated, especially during debt crises. An IMF working paper recently found that interest rates are highly dependent on how financial markets regard growth -- perhaps especially short-term growth -- in a country (Cottarelli and Jaramillo 2011). Indeed, research indicates that the challenges of structural reform are the largest barrier to long-term growth prospects (Auerbach 2011).

Many countries have been able to reform, and Eastern and Central Europe during the past two decades provide many powerful examples, where per person income has often doubled or tripled in post-Soviet nations. Most of the world, in fact, has liberalized in the past 30 years, as shown in the World Bank's Doing Business-index, with South-East Asia leading in reform and growth (World Bank). According to the Global Competitiveness Report and the International Institute for Management Development, the countries of Northern Europe are currently the world's most competitive (IMD 2011). This was not always the case, but is the result of several waves of structural reform since the late 1980s that have loosened labor markets, privatized government assets, and broken up large monopolies. In Sweden, Norway, Denmark, Finland, the Netherlands and Germany, growth remains better than in the rest of Europe. These countries are called upon to fix Europe's debt crisis, and are among the few Western nations not facing meaningful debt crises of their own. The United States has lost a few points in competitiveness in recent years, though it remains in a reasonably high position and demonstrates potential for growth-friendly reform apart from acute fiscal policy concerns, most obviously in simplifying the tax code.

Conclusions

Increasing government spending through borrowing in order to stimulate the economy has led to meaningful slowdowns in many of the countries in which it has been recently attempted. As deficits and debt have mounted, growth has plunged. Long-term effects on growth -- such as decreased productivity and the rising cost of paying back debt -- may impede growth for many years to come. The risks of following this policy were not unknown -- on the contrary, they were apparent already four decades ago -- and the effects of crowding out, poor political processes, errors in central planning and the effects of subsidies have not decreased in the decades since they were first explained. Some growth effects have become stronger, such as the free-flow of goods and services in the global economy. As the next crisis unfolds, the pains of current Keynesian policies must be remembered as cries to "do something" permeate the public debate.

Monetary policy and automatic stabilizers are two of the most effective ways to soften an economic downturn, as they are broad and non-selective. They too have disadvantages in terms of timing, risks for inflation, and growing budget deficits. Policies that set strict frameworks for public finances or long-term debt have been beneficial for the countries that use them, and they may make it easier for automatic stabilizers to work in the future. Decreasing public expenditure may also be beneficial for growth depending on how it is deployed. Micro-level structural reforms for competitiveness and a dynamic economy make a country stronger in long-term growth as well as in the bounce back from a crisis.

The idea of stimulus policy, especially in the form of increased public spending, relies on the "broken window fallacy", as formulated by the French 19th century economist and philosopher Frédéric Bastiat (Bastiat 1985). In his example, a shop-keeper has his window broken and subsequently repaired at a cost of six francs. This might be considered an economic stimulus, since it brings work and income to the repairman. Hence, we could break lots of windows in order just to repair them -- and why stop there? The point is that society is not in any way improved or moved forward by these extra expenses because they do not create new wealth. And, more importantly, while we see the repairs, but we do not see where the six francs had been spent if the window had remained intact. Most likely, it would have gone to something more productive than replacing destroyed capital. Keynesian stimulus policy leads to several effects such as debt build-up, crowding out, bad timing or simply less productive government-made choices that are similar to those in Bastiat's example.

The current debt crisis is very serious and is justifiably on top of the policy agenda. It demands accurate analyses, crisis management and political leadership. In this process, it is essential to study which policy measures have worked and which have not. Keynesian stimulus policies, with vast increases in public expenditure, deficits and debt, have been counter-productive. As an economic recovery comes, the lesson of Keynesian stimulus policy failure must not be forgotten. Such policy must be avoided when policymakers are faced with the next crisis, which will inevitably come, in one form or another. Long-term reforms for growth, balanced budgets and limited public expenditure should be in focus for governments as they emerge from the current downturn. The consequences of continuing or repeating failed policies -- or unwillingness to correct a harmful policy path -- will be serious.

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² Many thanks to Nima Sanandaji for an active role in the production of this document, as a highly qualified analyst and researcher.

³ See, for example, the New York Times Room for Debate feature on January 20, 2008 entitled "A Policy Debate Begins."

⁴ See a film here, where Krugman makes his case for preparations for inter-galactic war: http://kebnekaisegruppen.se/2011/08/16/intergalaktisk-stimulans/

⁵ For the current US debt, visit Treasury Direct at http://www.treasurydirect.gov/NP/BPDLogin?application=np

⁶ For an example of this, see Archibald Tuttle's post at http://www.dailykos.com/story/2011/04/14/966983/-The-federal-government-is-NOT-a-family

⁷ In general, terms used here, such as stagflation and Keynesianism are very simply defined. Further reading is recommended.

⁸ This development is well described in the Index of Economic Freedom from the Heritage Foundation and Wall Street Journal as well as the Economic Freedom of the World from the Fraser Institute.

⁹ Indeed, as Rother, Schuknecht and Stark (2010) point out, these linkages are precisely why fiscal engineering is dangerous and fiscal consolidations are required as a response to the current crisis. McKibbin and Stoeckel (2011) point out further that coordination in fiscal consolidations can increase the effect of smaller consolidations at increasing growth in the near term.

¹⁰ For a good overview of European and US crisis responses and stimulus programs see Nanto, Dick, K, The Global Financial Crisis: Analysis and Policy Implications, Congressional Research Service, October 2, 2009.

¹¹ All data from OECD and Eurostat.

¹² Dick Cheney elaborates on how they could have done more to control spending: http://www.mediaite.com/tv/dick-cheney-on-bush-era-spending-i-think-we-could-have-done-a-better-job/

¹³ The authors use a new empirical approach for identifying the impact of government spending on the private sector. Change in congressional committee chairmanship is used as a source of exogenous variation in state-level federal expenditures.

¹⁴ A brief summary that still provides some overview of the multiplier debate can be found in the latter part of Foster, J. D., Keynesian Fiscal Stimulus Policies Stimulate Debt -- Not the Economy, The Heritage Foundation, July 27, 2009

¹⁵ As argued in The Economist here, for example: http://www.economist.com/blogs/freeexchange/2010/07/fiscal_policy

¹⁶ In OECD, Going for Growth, 2011, there is a thorough compilation of the need for reform and lists of growth-friendly reforms supported by research findings.