Economic Stimulus Does Not Work

May 28, 2013

Throughout the last 50 years, there has been a clash in Congress between the two most prominent forms of economic thought: Austrian and Keynesian. Austrian economists believe in letting the market fix its problems without government intervention, whereas Keynesian economists believe that increased government intervention and spending in the economy will fix economic problems. Keynesianism has been triumphing in U.S. congressional policy lately. That belief system is founded upon assumptions that will harm America considerably in the future, says Economic Policies for the 21st Century.

Those who believe more government spending is the antidote to the current economic problems rely on multiple assumptions to defend their position.

  • The future costs of servicing debt issued to finance larger deficits don't matter or are trivially small.
  • The central bank can control future interest rates, so we need not worry about a spike in future borrowing costs.

Under the first assumption, the debt-to-gross domestic product (GDP) ratio cannot increase indefinitely because eventually the cost of maintaining public debt would end up draining all national income. Even if one believes a debt-funded stimulus would accelerate economic activity, there is likely to be some point at which compounding deficits will consume too much of future income.

Assuming interest rates of 5 percent, the additional 35 percent of GDP in debt the federal government has accumulated since 2008 would cost future generations 1.75 percent of their gross income.

  • Now 1.75 percent doesn't sound like a substantial portion of the U.S. economy, but 1.75 percent is equal to $280 billion of 2013 GDP and the 10-year costs of this interest expense would be $3.5 trillion at a 5 percent nominal GDP growth rate.
  • This is nearly three-times as large as the $1.2 trillion in 10-year cuts from sequestration.
  • Interest rates today are far from 5 percent. The Treasury can finance itself at a less than 1 percent weighted average rate, but the proponents of larger deficits argue that we need not ever pay the debt back, which could be disastrous.

Under the second assumption, the central bank becomes a hostage of the fiscal authority and "monetary policy." Under these circumstances, the Fed would be forced to choose to either:

  • Continue to suppress interest rates and accept the resulting inflation or financial instability.
  • Allow rates to find their natural level, which could leave the sovereign insolvent and result in some kind of sovereign restructuring akin to the Greek experience.

Source: "Government Spending Enthusiasts' Three Sleights of Hand," Economic Policies for the 21st Century, May 6, 2013.

 

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