Why Obama's Big Spending Fallacy Could Ruin U.S. Economy

I'm inclined to the view that the Great Depression was a seminal turning point in the history of economic thought. Thanks to that politically-induced tragedy something like 150 years of sound economic reasoning was overturned by two mercantilist fallacies that we now call Keynesianism, the first of which was the demand deficiency fallacy. This clearly leads to the second fallacy that increased government spending can promote growth, especially by encouraging consumer spending (1, 2). Both fallacies are responsible for the present economic crisis.

I have been publishing data for years that refutes both fallacies. Unfortunately Keynesianism seems to have taken on the characteristics of a cult that brooks no opposition — including contradictory evidence. Nevertheless, facts are facts and the idea that a high level of consumption as a proportion of GDP is needed to prevent unemployment from rising has been thoroughly refuted by statistical evidence as the following table amply demonstrates.

What's amusing about this table is that it reveals the so-called laissez-faire Hoover as doubling government spending as a proportion of GDP. (Hoover was well known at the time to being strongly opposed to laissez-faire policies. Thanks to the dishonest efforts of left wing historians this fact has been turned on its head). This increased spending in dollar terms was far from trivial. Robert P. Murphy points out that for the financial year 2007 the Bush administration would have had to run a deficit of $3.3 trillion to equal Hoover's "overspending". (Robert P. Murphy, The Politically Incorrect Guide to the Great Depression and the New Deal, Regnery Publishing Inc., 2009, p. 47).

The data also demolishes the idea that debt is counter-cyclical. From 1930 to 1939 total debt rose by 150 per cent and yet America continued to be cursed by widespread unemployment. (Debt is expected to be 101 per cent of GDP in 2010). So how do we account for the very high level of unemployment? What matters to employers is the cost of labour relative to the value of its marginal product. (Every introductory economics textbook explains this process). It obviously follows that if the cost of labour (the gross wage) exceeds the value of its product persistent unemployment will emerge.

The fourth column in our table contains the productivity adjusted wage. This is arrived at by dividing productivity by the real wage. We can now see that real wages did indeed exceed productivity — and to a considerable degree — with the tragic results that economic theory predicts. No matter which indexes are used the result is always the same: excess wage rates. What makes the third column particularly interesting is that though Canada had no New Deal her employment record during the 1930s was vastly better than the US's to the extent that on average the US unemployment rate was 3.9 per centage points higher. (Murphy, ibid., p. 104). An important fact that is usually overlooked is that the great bulk of the unemployed were in manufacturing. In 1934 it was calculated

that of a total of almost 14 million persons were without jobs at the peak of unemployment in March, 1933, 6½ million were from the durable goods industries, nearly 6 million were from the "service" industries, and only 1½ million were from the consumption goods industries. Investment activity, in a word, is the tail that wags the industrial dog. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 235).

It was noted at the time and is borne out by the figures in the table that consumption was in fact being maintained and that it was the producer goods industries that were suffering the most, a fact that Joseph Stagg Lawrence, an eminent economist, tried to point out to the public. (The same thing happened during the 2000 and 2001 recession). It was patently clear to the more astute economists that consumer spending was not the key to recovery.

Unfortunately for Australia Prime Minister Rudd is as profoundly ignorant of economics and economic history as is President Obama. Rudd is arguing that the Premiers’ Plan of 1931 that resulted in public spending cuts deepened the depression and raised the level of unemployment. However, Sinclair Davidson, a Professor in the School of Economics, Finance and Marketing at RMIT, produced a chart showing that unemployment not only peaked in 1931 it then began to fall despite government spending cuts.

Why? He doesn't say but the following chart provides a clue. Unemployment peaked when productivity reached its lowest point, after which it began to rise as did the demand for labour. But for this to happen the productivity adjusted wage would have to fall. The real wage in manufacturing for full-time labour in 1927-28 equalled 100. In 1930-31 it was still 100. For 1936-37 it was 99. During this period it never fell below 98. (C. B. Schedvin, Australia and the Great Depression, Sydney University Press, 1988, p. 350).

Now we have our answer. When productivity fell the productivity adjusted real wage rose which then raised the level of unemployment. Once productivity began to increase again this reduced the productivity adjusted real wage and so increased the demand for labour. Therefore, government increased borrowing and government spending had absolutely nothing to do with it. This the lesson of the 1930s and one the classical economists understood. Mill spoke for them when he wrote:

The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained. Taxes are not now esteemed to be 'like the dews of heaven, which return in prolific showers'. It is no longer supposed that you benefit the producer by taking his money, provided that you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasoning of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided that he expends it all again at the same shop, is a public benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman a fortune. (John Stuart Mill, Essays on Economics and Society, Collected Works of John Stuart Mill, Vol. I, University of Toronto Press 1967, pp. 262-63).

Unfortunately President Obama and his advisors are hell bent on imposing on America unsustainable deficits and spending for which there is no economic justification and whose only result will be a great weakening of the economy. Only an unreasoning and fanatical belief in the power of state can account for such behaviour.

1. The immediate post-war economic situation is highly instructive in that it completely explodes the Keynesian idea that government spending is vital if unemployment is to be prevented from rising. Between 1945 and 1947 the Truman government slashed Federal annual spending from $95 billion to $36 billion — a $59 billion cut in two years, a 62 per cent reduction that amounted to 26 per cent of GDP as it stood in 1945. Instead of the mass unemployment that Paul Samuelson confidently predicted would emerge when the war ended and government spending was slashed America entered an unprecedented period of prosperity.

2. In fact, recovery was already underway before Roosevelt could implement his destructive New Deal policies. Roosevelt was inaugurated on 4 March 1933. I don't want to be a party pooper but the depression bottomed out "in the late winter of 1932-33" and recovery was clearly underway in the February-March period with the Federal Reserve Index of Production rising from 60 to 100 in July. (Frederick C. Mills Prices in Recession and Recovery, National Bureau of Economic Research, Inc., 1936, p. 307).

Comments

[Dave Wrixon:]

Change the "Could" to "Will" and you get my vote!

Aug 05 07:32 AM

[wavelength:]

Nice to see not just excellent historical analysis but also an international perspective. As an ex-pat Australian I am saddened by the manner in which Prime Minister Kevin "profoundly ignorant of economics and economic history" Rudd's government is destroying the foundations laid by the Howard government. The only thing missing is a discussion of the Laffer curve. If the US administration is already weeping over the dip in tax receipts, well just stick around.

Aug 05 08:54 AM

[Tony Petroski:]

I agree with the thrust of the article and, of course, don't contradict the great Mill, but you are operating under the assumption that both FDR and Obama want to "fix" the economy. The technocrat Hoover wanted to fix the economy as a good engineer would. But FDR and Obama want to create a dependency class of people served by government workers thus cementing a permanent democratic majority as far as the eye can see. Obama may be ignorant of classical economics but he can afford to be.

Can we?

Aug 05 09:04 AM

[j-dub:]

psst..........
It's already ruined.
How long it'll stay that way is up to Obama and to some extent, the American people.

(It's amazing what a phony stock market rally can do to trick the mind)

Aug 05 09:06 AM

[Mike Conlon:]

Brilliant analysis based on historical facts, and not populist rhetoric.

Aug 05 09:14 AM

[The Geoffster:]

Keynesianism arrived just in time to save capitalism from nascent communism which was all the rage among western intellectuals. What we got was nascent socialism instead. The U.S.has been feasting on government spending ever since. Voters believe they are entitled to rely on the government for their basic needs. This used to include public transportation but now includes private transportation as well. Health insurance too costly? Pass the cost on to your grandchildren. Don't reform the insurance business. That would benefit the capitalists. In China, people are saving too much. The solution proposed by Washington- implement more entitlements so people don't have to save for old age! Is it any wonder this Ponzi scheme has collapsed?

Aug 05 09:20 AM

[John Galt:]

You point out that Herberg Hoover really strongly opposed to laissez-faire policies but pop media call him the "conservative". I believe the same thing will happen over time with Bush. In 50 years the socialists will say that the "laissez-faire" George Bush got us into this mess, and the socialist Obama saved us or helped ease the pain.

Why can't we just leave the economics to the economists? Most people say "economics is hard", or they never took a single course on it yet they are quick to say how to run an economy "free health care"!

Keynsian economics died decades ago but still lives on because politicans need a way to rationalize their theft.

Obama, the former community organizer and lawyer has about as much economic training as his low income voter block. We are left with moral arguments coming from a laywer of all people.

Aug 05 09:56 AM

[Gregman2:]

Overconcentrated wealth that's not recirculating through the system is the problem right now. The roots at the base aren't getting any water, while the top has an over abundance of water, hence imbalance. How to recallibrate? Attempts are often made using redistributionist schemes. But no matter what steps are taken, redistribution in various forms are needed to stimultae the system to
begin the process of organic rebalance.

Aug 05 10:24 AM

[Leftfield:]

It's true that pay in excess of productivity would cause unemployment. But, our system is loaded with artificial good jobs and misallocation. How do you measure "productivity" of government workers and most lawyers? They subtract from private productive output. As for Wall St., the "Citadel of Capitalism," I have several lifetimes of contempt.
I don't need to hear defenses of the Lawyer-in-chief's Carter-on-steroids, Chicage machine politics because George the Stupid also sold us out. I see a system that clearly left the middle class a hollow, indebted shell during "prosperity" and we're propping up failure to every last breath of our grandchildren.
This article sheds light on the truth.

Aug 05 02:25 PM

[GeminiAtlas:]

This might bring up a quandary for a politician looking for the solution to "fix" the economy. The exact or at least best solution is to do nothing and let the economy fix itself. But a politician can't be seen "doing nothing." That would be unseemly and certainly doesn't get votes. So the politician tries to fix things and invariably makes the problems worse, but at least he is "doing something about it" and remembered for the grand attempt even if he is exactly wrong.

Aug 05 03:09 PM

[Valley Boy:]

President Truman, underlike F.D. Roosevelt, was one of those presidents who were successful at encouraging a healthy economy.
It is instructive to study the presidential actions which were actually successful at promoting prosperity.
I am tired about reading how great F.D. Roosevelt was about fighting the Depression. He had mixed results at best. The Obama Administration can certainly find better administrations to emulate.

Aug 05 03:46 PM

[atlasman:]

If you want to recirculate wealth, lower capitol gains taxes.

If you want wealth to disapear, try taking it.

-AM


On Aug 05 10:24 AM Gregman2 wrote:

> Overconcentrated wealth that's not recirculating through the system
> is the problem right now. The roots at the base aren't getting any
> water, while the top has an over abundance of water, hence imbalance.
> How to recallibrate? Attempts are often made using redistributionist
> schemes. But no matter what steps are taken, redistribution in various
> forms are needed to stimultae the system to
> begin the process of organic rebalance.

Aug 05 07:27 PM

[sether:]

Umm, the US Economy is already ruined, bro. And I think I could come up with another group of carefully bracketed charts and cherry-picked statistics to make a different argument, or any number of different arguments, each citing as many books and economic theorists as yours does. The 1980's ended in 2008. Any economic policy which contrasts with those in vogue over the last 30 years is a good one.

Aug 05 09:14 PM

[Vox Rationalis:]

I've read a couple of your pieces now, and it seems like you have one point and one point alone: that during the depression, real wages were too high, and so unemployment resulted.

Well, no kidding. Here's another way to say the same thing: monetary policy failed on a massive scale, resulting in a deflationary depression. Wages are sticky, so they don't fall. Voila.

Now, your data have a couple of problems. Your favorite statistic, the "productivity-adjusted real wage" (PARW), remained above 1.00 throughout the 1930s, and was actually higher in 1939 than it was when unemployment peaked in 1933. If this statistic being higher than 1.00 is indicative of wages being too high, why then did unemployment decline following 1933, when PARW was never lower than 1.14?

Lastly - you've provided no discussion of any similarities between the 1930s and today, so the real question is: so what?

Aug 05 09:48 PM

[E Nuff Sed:]

The elephant in the room is the fact that the USD is the reserve currency and its value is relative. This makes it easy and cheap for the government to borrow and spend. This was not true in the 30's when the dollar was tied to gold.

The obvious consequence is that in the future the relative value of the dollar will be deflated (and so will the value of the debt). Imports will go down and export will go up and ship will stabilize.

Aug 05 11:37 PM