Which Federal Policies Help or Hurt Economic Growth?

Issue Briefs | Economy

No. 115
Tuesday, October 02, 2012
by R. David Ranson

In the last several years Washington has experimented with larger economic interventions than ever before — yet, year after year, the economy merely trudges along.  The recovery from the 2008-2009 recession has been unusually weak.  All agree that something is seriously wrong, but theories as to what the problem might be range from one extreme to another.

One side argues that we must do much more of what has failed. The opposite view is that we should reverse direction. Though politicians do not want to hear what history can tell us about how to break out of the malaise, the solution, found in a careful analysis of economic history, is amazingly simple.

In order to stimulate economic growth, the federal government should stabilize the dollar, freeze and reduce its spending, cut tax rates, and let the markets set interest rates freely.

The Relationship between Economic Growth, Public Budget Deficit and Gold Prices. Since its lowest point in the second quarter of 2009, real gross domestic product (GDP) has been growing at a far slower rate than previous cyclical recoveries: 1.75 percent per year through the first quarter of 2012. This has happened either despite or as a result of energetic deficit spending. Figure I compares GDP growth with federal debt over this period.2

Figure I shows debt held by the public, which excludes U.S. Treasury obligations held by other federal institutions (expressed in nominal dollars). Currently, public debt is growing three times faster than the economy. During a recession, public debt often grows while the economy shrinks, but it highly unusual for debt to grow faster than the economy in the third or fourth year of recovery.

Is the growth of public debt good or bad for the economy? Table I divides U.S. history since 1810 into 20 consecutive decades, with the decades that included the Civil War and World Wars I and II in a separate category.3  The table reveals a clear inverse relationship between federal borrowing and economic growth from decade to decade.

Federal tax revenue automatically parallels low economic growth, and that in turn implies more government debt. In theory, a budget deficit can result from either excessive spending or insufficient tax revenue, or both. To determine what the case is, it is necessary to separate the spending side of the budget from the revenue side, then determine the extent to which federal spending grows faster or slower than the economy.

Table I also shows that deficit spending is conducive to depreciation in the value of the dollar in terms of gold. The faster the debt grows relative to the economy, the more the dollar price of gold rises, in time driving up prices throughout the economy. Deficit spending does not stimulate economic growth, but does stimulate inflation.

Federal Spending Crowds Out Private Spending. Table II displays calculations similar to those in Table I, but classifies decades according to whether federal spending relative to GDP increased or decreased.4  The inverse correlation between debt and the economy shown in Table I is not merely a result of the tie between GDP and federal revenue. Over time, the faster government spending increases relative to the economy, the more slowly the economy grows.

There is also substantial evidence pointing to an inverse relationship between what is erroneously called stimulative fiscal policy and the economy’s performance. Purchases of goods and services by the private sector, and by the public sector, add up to total GDP. Figure II shows years in which the government’s share of GDP changed, grouped according to the size of the increase or decline, and the average response in the private sector’s share for each group.6 Figure II reveals that there is an inverse relationship between them:  Excessive public spending “crowds out” spending by the private sector.

The correlation is not only clear, but linear and proportionate. The difference in the private component of output shown in the left-hand and right-hand bars is 51.8 percentage points of GDP. The corresponding difference in the public component of output is 75.2 percentage points of GDP. This implies that the average dollar spent by government results in about two-thirds of a dollar of reduced private sector spending. This calculation is conservative because it does not include a further inverse relationship between government purchases and private purchases one or more years in the future.

Crowding out also takes place in the labor market. Advocates of government intervention argue the government can at least partially solve the unemployment problem by adding to its own payrolls. Figure III shows the average net change in total employment in and following years government employment increased or diminished.

In the average year since 1962, government employment increased by 273,000. Total employment increased slightly more in years government payrolls went up more than usual than it did in years government payrolls went up less than usual. But the net gain is unimpressive:

For every additional government worker, roughly half a private worker disappears, leading to a net gain of only half a worker.

Over a three-year period, every government employee added results in a reduction in total employment of more than three workers!

Far from helping to solve the unemployment problem, government hiring reduces the ability of the private sector to create jobs to such an extent that total employment is actually reduced. This result seems counterintuitive and puzzling until one remembers that neither the government nor the private sector can hire a worker unless they commit resources and capital to make sure that worker is productive. The resources and capital used by the government must originate in the private sector and, of course, have to be appropriated by taxation or borrowing.

If it takes three times as much capital to fund a productive government job as it does to fund an equally productive private job, each government job created could very well subtract three or four private jobs. This is more than a mere crowding out of private economic activity; it is a waste of scarce resources.

Among economists, even simple “crowding out” is a contentious subject. Few pay much attention to the concept, and many deny it occurs. But with reference to pre-Keynesian times, the economy can sensibly be viewed as a finite system in which resources, spending or jobs cannot be created out of nowhere. They can be created in one part of the system only at the expense of other parts. The economy does not grow because something is added to it, but as a result of more efficient use of resources, better management decisions by its participants, or simply greater vitality. And nothing depletes vitality more than uncertainty or fear.

Figure IV is a simplified way to illustrate the nature of a classical economy, identifying the four major ways in which its size, prosperity or performance can be measured.7 These four economic measures are:  output of goods and services, the inputs of labor, capital and other resources required to generate this output, the income obtained by the owners of these resources when they are hired by producers, and spending by the receivers of this income. In a perfect accounting system they would all be equal.

The fourfold symmetry is reminiscent of another classic tenet of economics, that supply and demand are two sides of the same coin. At this extreme level of simplicity, output, input, income and spending can be viewed, similarly, as four sides of the same square!

Relationship between the Economy and Other Macroeconomic Policies. If the federal government cannot boost output and employment either by increasing its spending or by adding directly to its payrolls, perhaps it can use tax policy to stimulate the economy.

There is an instinctive belief that stimulus from tax rate cuts must be paid for by lost tax revenue. However, the evidence contradicts this assumption. Empirically there is a tax-rate structure that maximizes revenue. Tax rates lower than the maximizing rate enlarge the tax base but generate less revenue. But tax rates higher than the maximizing rates cause the tax base to shrink so much that they cost the government more revenue than they collect. The fact that federal revenue has never surpassed 20 percent of GDP consistently suggests that tax rates in excess of 20 percent may well be revenue losers. This empirical finding is known as Hauser’s Law.8

The sensitivity of the economy to changes in tax rates, especially top income tax rates, is also controversial. Table III shows that decades in which the top marginal income tax rate increased were decades of inferior economic growth and stock market performance.9

The relationship between top marginal tax rates, economic growth and stock market performance does not appear to be linear. This suggests that changes in tax rates are disruptive and that the benefit of small reductions in tax rates might be undercut by the cost to taxpayers of adapting to the change. Constant changes in tax rates, or merely uncertainty about tax rates, are counterproductive. Thus, there is strong evidence that the federal government cannot do much to improve output and employment using fiscal policy in the conventional, counter-cyclical way.  However, the evidence shows that reductions in marginal tax rates of 10 percentage points or more lead to higher levels of investment and higher stock prices.

Some skeptics who agree about the ineffectiveness of fiscal policy conclude that monetary policy (interest rate management or quantitative easing) must bear the whole burden of stimulus. But broad experience in many countries suggests that artificially low interest rates produce lower rather than higher growth rates.10

Even the creation of new money via the monetization of the debt fails to boost the economy, according to historical evidence from the varying growth of bank reserves in the decades since World War I.11  Table IV contrasts economic performance in peacetime decades during which the monetary base grew faster and decades in which it grew slower than usual. (The decade that includes World War II is reported separately.) 

Table IV shows that higher growth and better stock-market performance occur when the Federal Reserve creates less rather than more money! Moreover, debt monetization stimulates the rate at which the dollar depreciates, as expressed by the price of gold. In this sense, easy monetary policy stimulates inflation but not growth.

A fall in the dollar results from fiscal policy (the growth of debt shown in Table I) and monetary policy (the growth of the monetary base shown in Table IV). But it is also a policy in its own right.

Figure V summarizes the evidence concerning government stimulus and restraint or, more specifically, the distinction between “true” and “false” stimulus. Figure V shows the economic implications of a rise and a fall in the price of gold. Rises in the gold price are followed by slower growth in both (a) real GDP and (b) employment, and declines are followed by faster growth.

The sensitivity of employment to changes in the value of the dollar is only half as great as the sensitivity of output to changes in the value of the dollar. This suggests that one of the consequences of a decline in the dollar is lower labor productivity.

Conclusion. The historical evidence explains why the economy is performing so poorly. Many policies pursued by the Obama administration, as well as some pursued by the preceding Bush administration, have widely been thought to be stimulative. They have led instead to prolonged economic weakness, a careful reading of history suggests. To turn the situation around, Washington needs to stabilize the dollar, freeze and reduce spending, cut tax rates, and let the markets set interest rates freely.

Ironically, economic stimulus implies government restraint. Copious evidence covering many decades shows that activist policies such as government spending, government employment, and the creation of money tend to restrain the performance of output, employment and stock prices. If so, the current failure of the economy to recover rapidly from the 2008 recession is easy to explain, since policies advertised erroneously as “stimulus” have been pursued on an unprecedented scale.

Endnotes

1. Adapted from David Ranson, “What Federal Policies Have Historically Been Conducive to Superior or Inferior Economic Growth?” presentation to Congressional staff sponsored by the National Center for Policy Analysis, Washington, D.C., June 26, 2012.

2. Updated from “The Price of Gold in the Long Run,” Strategic Asset Selector, H.C. Wainwright & Co. Economics Inc., March 25, 2010, Figure One.

3. “Two Centuries of U.S. Experience with Balanced and Unbalanced Budgets,” Strategic Asset Selector, Wainwright Economics, November 25, 2010, Table 1.

4. “Good and Bad Debt — Good and Bad Austerity,” Economy Watch, Wainwright Economics, January 30, 2012, Table 2.

5. Roy W. Jastram and Jill Leyland, The Golden Constant (Cheltenham, England: Edward Elgar, 2009).

6. Updated from “Good and Bad Debt — Good and Bad Austerity,” Figure Two.

7. “Contrary Economics for Troubled Times,” The Capitalist Perspective, Wainwright Economics, October 31, 2010, Exhibit 1.

8. For historical data, see “Washington’s Inability to Forecast Its Own Fiscal Picture,” Economy Watch, Wainwright Economics, April 30, 2011, Figure Three.

9. “The Impact of Changing Income Tax Rates on the Stock Market,” Strategic Asset Selector, Wainwright Economics, January 24, 2011, Table 2.

10. “The Role of Zero Interest Rates in Subnormal U.S. Recovery,” Interest-Rate Outlook, Wainwright Economics, February 29, 2012.

11. “In Combination, Washington’s Tax and Monetary Policies Can Be Lethal,” Strategic Asset Selector, Wainwright Economics, September 22, 2011, Table 2.


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