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Will the Obama deficit-spending plan work? Will throwing $800 billion—$500 billion in extra government spending, and $300 billion in tax cuts—at the economy produce a world in which production and employment are higher and unemployment lower than would otherwise have been the case?

The short answer is yes. The short reason is that spending works—eras when some group or other gets excited about future prospects and starts spending money like water are eras in which production and employment are high and unemployment low. And the government, in this respect, is just like any other group of starry-eyed optimists whose eagerness to spend pulls the economy into a high-employment high-pressure boom.

Between 2003 and 2005, the assembled investors of the world discovered the American housing market. Low interest rates produced by the Federal Reserve allowed them to borrow and leverage up cheaply—and the promise of financial engineering that would greatly help them diversify risk made them think investing in funding new construction and new homeowners’ moves in to new construction was a profit opportunity.

Spending on building houses rose. And the adult civilian employment to population ratio rose from 62% to 63.5% as the unemployment rate fell from 6.0% to 4.8%.

Between 1996 and 1998 the assembled investors of America discovered the internet. And the adult civilian employment to population ratio rose from 63% to nearly 65% as the unemployment rate fell 5.6% to 4.3%.

Figure 1: The Adult Civilian Employment to Population Ratio

In August of 1982 Paul Volcker’s Federal Reserve released the interest-rate chokehold it was using to strangle the economy. Lower interest rates induced homebuilders to spend massively as for the first time in nearly half a decade they could obtain financing for construction. At the same time, the Reagan administration ramped up defense spending for the second cold war, and luxury spending rose as the Reagan tax cuts gave more of their own money back to America’s rich. The adult employment-to-population ratio rocketed up from 57.2% to 59.9% in the short order of two years as the unemployment rate fell from 10.8% to 7.3%.

These are just three examples of a general principle: each major business cycle expansion we have seen has been driven by a leading wave of spending—by some group that becomes enthusiastic about their prospects and decides to greatly up its spending. And that pulls employment and production up.

Now we are attempting to do the same thing once again—but this time with the government as the leading spender. A boost to spending by the government should have the same effects as the boosts to spending by luxury consumers and the defense department and homebuilders in the early 1980s, as the boost to spending by the high-tech sector in the late 1990s, and as the boost to spending by homebuilders in the mid-2000s. The government’s money, after all, is as good as—is the same as—anybody else’s.

So there is little question as to the likely impact of the Obama deficit spending program: production and employment are going to be higher than they would have been otherwise.

But there is a relevant remaining question: will there be some sort of a hangover after this Obama spending binge—and if there is a hangover how bad will it be? For that, you will have to wait until next time.

Source: Why Obama's Deficit-Spending Plan Will (Probably) Work