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

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.

Comments

[Noleen:]

Good article. I'm concerned about the same thing.

How can this spending program based off printed money not lead to hyper inflation ?

The ratio between wages and prices - the ratio of money to products and services available - that is what determines a economic forces.

The only end of this insane "investment program" is hyperinflation, double-digit unemployment and free market shrinkage or collapse.

Why did we allow this to happen again?

Feb 24 05:43 AM

[Ferdinand E...:]

Beautiful. Just what I needed to hear. And the best part of all is that it comes from the author of a reasonable macro book. As for the hangover. who cares if the spending binge works. After all, President Reagan went on a borrowing binge, and a few months ago even intelligent presidential hopefuls were talking about the 'Reagan Revolution'.

Feb 24 08:34 AM

[Bill Jencks:]

Huge deficit spending, tax-cuts, supply side economics have NEVER been proved to work on there own in any dire economic situations or models. These Keynesian methods are pie-in-the-sky, chosen very conveniently by polititians and not real economists to make themselves popular, to polish their own bent images. Harsher fiscal remedies are never allowed, since politicians continually pray for another dodgier way than heavily taxing there own people and businesses. This only prolongs the economic agony.

Try Googling "Kotlikoff and Menu of Pain" to see a realistic remedy for America's huge Fiscal Deficit.

Feb 24 08:37 AM

[Trane250:]

Back in the early 80's, we still manufactured most of the products that we consumed. Last year, we had a $440 billion trade deficit in manufactured goods. The people (aside from those in the educational establishment)likely to be helped by all of the deficit spending reside in foreign lands.

Feb 24 09:37 AM

[Fred Hapgood:]

"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."

Seems like a completely different situation to me. Obama etc. is not "spending money like water" because he is "excited about future prospects" but because he is terrified of them. The psychology of the two situations -- like the dot-com splurge and this one -- could not be more different. I trust this is not a controversial observation.

Feb 24 12:37 PM

[Casey Driskell:]

I agree with Bill. Deficit spending has never proved to work in the past, so why should it start to now? It didnt cause immediate effects or decidedly cause the Great Depression to lift 7 decades ago. Our government is just becoming more and more invovled in our everyday lives and digging themselves a deeper debt hole. I think that this stimulus package will do just that and send us into a deeper spiral than we are already in.

Feb 24 12:43 PM

[PT AP:]

Sure, let's just encourage another massive re-leveraging so we can go repeat this again in a few years.

The above policies & cycle summaries can more or less be distilled along these lines....

Gov't Intervention -> Credit/Asset Price Bubble -> Overly Optimistic Expectations -> More Debt -> Higher Asset Prices -> Bad Investment (& Higher Employment) -> More Debt -> Higher Asset Prices -> Unsustainable Debt Servicing/Insolvency -> Crash ->

Prescription: Gov't Intervention -> Reflate Credit/New Bubble -> Overly Optimistic Expectations -> ......-> Even More Leverage -> Even Bigger Crash.

Rinse. Repeat.

Total US Private & Public Debt/GDP:
1950 - 125%
1960 - 145%
1970 - 145%
1980 - 150%
1990 - 230%
2000 - 260%
2003 - 300%
2008 - 350%
2012 - 450%??

What's sustainable?

Feb 24 01:04 PM

[P. Kalven:]

Yes I remember that recession too; protectionism has led the way to several wars through history, so I'll pass on this line of thought.


On Feb 24 09:37 AM Trane250 wrote:

> Back in the early 80's, we still manufactured most of the products
> that we consumed. Last year, we had a $440 billion trade deficit
> in manufactured goods. The people (aside from those in the educational
> establishment)likely to be helped by all of the deficit spending
> reside in foreign lands.

Feb 24 04:59 PM

[_VM_:]

>> 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. <<

The government doesn't have extra money just floating around waiting to be worked. They must either print it, or borrow it. We know what happens when you print it - inflation. If they were to borrow it, they are just transferring the decision as to where to invest the money from the private sector to the public sector. And why would a massive government like the US all of a sudden make smarter bets than the market? They don't have insider information. They don't have the best talent. All thats left is luck.

Feb 24 05:19 PM

[meissmic:]

I must admit I am shocked reading the article above. The basic presumption that the government’s inefficient allotment of borrowed money on projects of friends and political supporters is as efficient as free market drive for growth and profit reminds me books I had to study in one of the Soviet Block countries. The presumption is so blatantly borrowed from ‘centrally planned economy’ books that I do not even see the point to argue. The history of government run economies is well known even to small children.

What shocks me more (although it does not surprise me) is that the new government does not want to give proper attention to the clean up of financial markets, capital gains tax cuts and stock market recovery leading to improved net worth perception that in turn restores consumption. Cutting capital gains tax cuts now costs nothing, however, such move brings much better short term economic results than building a fast train connection between LA and Vegas. Yes, I know politically the train is a much better solution while talking about capital gain tax cuts is evil in a Marxist economy.

Feb 24 09:59 PM

[Quick Loans:]

USA new President Barack Obama is faced with more than many challenges. He has some serious ideas about the economy, beyond just the enormous amount of quick loans that he made to the nation. He also has set his sights on cutting down the national deficit. The U.S. is currently about $1 trillion in debt. President Obama is looking to cut it in half – despite having just made $787 billion in quick loans. There has been an annual deficit for the last few years running, yet the Obama deficit may end up as a contradiction in terms, if he has his way. That would be worth making all those quick loans now, if it means investing in the future.

Feb 26 12:27 AM

[Quick Loans:]

USA new President Barack Obama is faced with more than many challenges. He has some serious ideas about the economy, beyond just the enormous amount of quick loans that he made to the nation. He also has set his sights on cutting down the national deficit. The U.S. is currently about $1 trillion in debt. President Obama is looking to cut it in half – despite having just made $787 billion in quick loans. There has been an annual deficit for the last few years running, yet the Obama deficit may end up as a contradiction in terms, if he has his way. That would be worth making all those quick loans now, if it means investing in the future

Feb 26 12:31 AM

[Carousel:]

A horrible comparison of private investment versus goverment spending. Why? Goverment isn't concerned about risk, ROI, or capital. Additionally linking goverment spending to the cyclical ups and downs of the market is equal to the broken clock analogy. Finally, the goverments money is not as good as everyone's else because the money is everyone elses. The goverment is either printing, borrowing, or stealing it. Its not earned by bringing something of value to the economy.

Mar 02 09:03 AM