Why Less Government Spending Would Mean Less Economic Trouble

Many economists say deficit spending is crucial to keeping the economy moving. But history tells a different story.

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Though our current economic troubles are complex, many mainstream economists have endorsed the simplistic Keynesian theory that massive government spending will produce jobs and prosperity.

From such Keynesian thinking have flowed the “stimulus” and bailout measures that have increased the size and power of government and added trillions of dollars to the public debt. The federal deficit has jumped from about 3 percent of gross domestic product (GDP) in fiscal 2008 to about 10 percent of GDP in fiscal 2009 and 2010. The government now forecasts deficits in the neighborhood of $1 trillion per year for the next decade.

Politicians, who are always looking for plausible rationales for their insatiable spending, borrowing, and power-grabbing, had never abandoned Keynesianism, so they have been elated to find economic “experts” again confirming their self-interested inclinations. Indeed, several prominent economists, such as New York Times columnist Paul Krugman, are urging Washington to spend even more, lest the economy slow.

But what does history teach?

History teaches that temporary surges in government spending give people money that, for the most part, they save or use to reduce debt, rather than setting in motion an upward spiral of income, expenditure, real output, and employment, as envisioned by John Maynard Keynes, the British economist whose theory spurred massive government interventions in the economy from the 1930s onward.

History also teaches that government “emergency” spending tends to fatten the coffers of the politically connected. Thus, much of the so-called stimulus spending has served only to increase the pay and benefits of government employees, transferring income from the private sector to the government sector, and to reward groups, such as the United Auto Workers and low-income home buyers, for their support of the Obama administration.

One aspect of the current crisis that has come as anything but a surprise to students of history is that the politicians (in the words of President Obama’s chief of staff, Rahm Emanuel) have not allowed this crisis “to go to waste.” The past two years have witnessed one power-grab or institutional takeover after another, including AIG, Fannie Mae, Freddie Mac, General Motors, and Chrysler.

Under the Troubled Assets Relief Program, the Treasury has taken ownership positions in hundreds of large banks by purchasing preferred shares and warrants. Virtually all residential mortgage lending now ultimately springs from the secondary market and guarantees provided by Fannie, Freddie, Ginnie Mae, the Federal Housing Administration, and Veterans Affairs.

This aspect of the government’s power-grab has been especially important because by continuing to pump funds into dodgy mortgages, the government is preventing the necessary restructuring of the housing-construction industry and the mortgage-credit sector, propping up unqualified and underwater borrowers and ill-managed and even insolvent lenders. These short-sighted actions create great potential for a second round of the housing crisis.

Since the early 20th century, periods of national emergency—real and imagined—have triggered sharp increases in government power, scope, and cost.

The first five episodes were World War I, the Great Depression, World War II, the upheavals associated with the civil-rights revolution and the Vietnam War, and the post-9/11 events associated with the war on terror and U.S. engagements in Afghanistan and Iraq.

We are now in another such critical period, springing from the housing bust, financial debacle, and recession.

In their embrace of Keynesianism, many economists have concluded that even though the New Deal’s hodgepodge of policies never brought about full recovery, World War II did, as the economy expanded to produce munitions and enlarge the armed forces. Huge, deficit-financed government spending, they argue, finally wiped out the lingering mass unemployment.

The truth, however, is really quite simple. In 1940, after eight years of New Deal pump priming, the unemployment rate remained about 10 percent even if, unlike the Bureau of Labor Statistics, we count people enrolled in federal emergency work-relief programs as employed. The gigantic buildup of the armed forces, primarily by conscription, then pulled the equivalent of 22 percent of the prewar labor force into the military. Voilà, unemployment disappeared, as it was bound to do regardless of any wartime Keynesian fiscal policies.

Looking to the World War II model of how to deal with today’s economic crisis is nonsense. Whatever else the war might have accomplished, it did not produce conditions that we may properly describe as genuine prosperity.

Government spending—whether on our current armed forces and their more than 800 foreign bases or on “green” energy and other government-favored projects—does not produce prosperity. It only diverts resources, as it always has in the past, from the genuinely productive private economy and bulks up an already bloated government.