- The Washington Times - Tuesday, September 14, 2010

Is the recession’s great irony that government spending killed Keynesianism? With economists, bankers and investors perplexed over the economy’s continued funk, we cannot be blamed for looking in odd places for answers. Could it possibly be that continuously increasing spending over eight decades has left little ability for government spending to affect the economy?

How could increased overall government spending have priced stimulative spending out of the market? To understand what has happened, we must look back to the 1930s. The New Deal was a concerted effort for government to take up the economy’s slack.

In 1930, federal government spending (a 6 percent nominal increase from 1929) amounted to 3.4 percent of gross domestic product (GDP). Under President Franklin D. Roosevelt’s New Deal, federal spending would top out at 10.7 percent of GDP in 1934 - only breaking the 10 percent threshold twice more in the 1930s. The increase of government relative to the economy was roughly threefold.

In contrast, the federal government consumed 24.7 percent of America’s GDP last year. As large as the economic stimulus nominally was, it was just a fraction of the nation’s $14 trillion economy.

While arguments still rage as to the New Deal’s efficacy, at least government intervention was fiscally plausible then. Because of the government’s previously minor economic impact, it could grow so much larger because it historically had been so much smaller.

In that regard, it was in line with John Maynard Keynes’ own theorizing. He had envisioned government performing a countercyclical economic function. Government intervention would increase during an economic downturn but, just as important, it would decrease once the economy recovered. It would dampen the cycle he believed to be inherent in the economy: eliminating innate volatility by filling in the troughs and pulling down the peaks.

Washington was happy to embrace Keynes’ theory to advance government growth, thereby putting more resources into its own hands. It welcomed increasing government intervention during economic downturns but resisted decreasing it in recovery. While Keynes’ goal was economic, theirs was political.

Keynesianism was taken only semiseriously in Washington - the spending half of the theory. Today, the federal government’s share of the economy is roughly 2 1/2 times its New Deal peak. Even absent the current downturn, the Congressional Budget Office only projects its further increase as entitlement spending swells.

As a result, it is no longer possible for the government to administer the economic jolt it attempted in the 1930s. At a quarter of the economy now, government could hardly triple economically as in the 1930s. Today’s large nominal increases in spending amount to little relative economic impact.

Indeed, these increases actually could have a perversely opposite effect. When government was historically small, the reasonable expectation was it would return to historical levels with economic recovery. Eight decades and a much larger government later, this is hardly today’s expectation. Increased economic intervention now may be tapping into underlying concerns of deficit, debt and taxes - offsetting any stimulative effect.

The assumption government will not retrench could be a rational expectation at this juncture. In 1934, the federal budget deficit was 5.9 percent of GDP. Last year, it was 9.9 percent of GDP - only slightly less than 1934’s total federal spending percentage.

Increased government spending could then be having an expectation effect similar to inflation. Inflation, in a historically stable money supply, can temporarily stimulate, as its effects are not readily recognized.

Over a prolonged period however, inflation is recognized, and the reaction is quite different. The market builds in premiums to offset inflation’s effects. The negative effect is factored in immediately, eventually more than offsetting any stimulative effect an inflated money supply might have.

Is such the case, over a much more prolonged period of time, with government spending today? The current expectation is that government spending is high and will only increase. An attempt, therefore, to use a spending increase temporarily to jolt the economy is not only more difficult, but may not work as it might have 80 years ago.

It could be adding yet further uncertainty to the economic uncertainty already prevailing. Financial markets brace themselves not only for the current downturn but for the aftereffect of having raised the spending base line still higher.

With economic tools running low and economic results running even less, we must search harder for an explanation. The government is dramatically larger than anything that could have been imagined when Keynes’ theory prevailed. Government spending may be such a large part of the economy that it can no longer serve as an exogenous stimulant.

J.T. Young served in the Department of Treasury, the Office of Management and Budget and as a congressional staff member. He is now a registered lobbyist.

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