Debate Club

Government Spending Shrinks the Private Sector

By SHARE

Both George Bush and Barack Obama implemented stimulus to bolster economic activity. So let's look at the latest attempt to use government spending to jump start the economy: the American Recovery and Reinvestment Act. Three years after Congress passed that law, unemployment lingers over 9 percent, far above the promised 7.25 percent, and the economy remains weak. Clearly, the stimulus didn't work as advertised. There are two main reasons why not.

First, contrary to claims of stimulus proponents, economists are far from having reached a consensus about the actual return of government spending. Some respected economists find every dollar in government spending means more than a dollar of economic growth (a large positive multiplier in economist speak), but others find every dollar in government spending results in less than a dollar of economic growth (a negative multiplier). After reviewing the academic literature, my colleague Matt Mitchell found that the median multiplier in relevant studies is 0.87, far lower than the administration's claim that every stimulus dollar would produce $1.57 worth of activity.

[See an opinion slide show of 10 wasteful stimulus projects.]

Second, even if one believes that government spending could trigger sustainable economic growth, the design of the stimulus bill was such that it could not have stimulated anything:

During the law's tenure, economists explained that instead of using the money to increase government purchases, states chose to use the money to close their budget gaps. This choice meant that the money went to keeping school teachers in their jobs and paying public sector workers, rather than to creating jobs in the private sector. Furthermore, the spending wasn't timely: Three years after the law was adopted, some programs still have managed to spend only 60 percent of the appropriated funds. Not only was the spending poorly timed, it also wasn't targeted. The data show that stimulus money wasn't targeted to those areas with the highest rate of unemployment. In fact, a majority of the spending was used to poach workers from existing jobs in firms where they might not be replaced. Finally, a review of historical stimulus efforts shows that temporary stimulus spending tends to linger. Two years after the initial stimulus, 95 percent of the new spending becomes permanent.

[Check out a roundup of editorial cartoons on the economy.]

The law may not have worked, but could other stimulus spending work? One could say that under the best case scenario, the existence of large multiplier, a perfect implementation, and an absence of massive debt accumulation, there is a chance that stimulus may deliver some results. That level of optimism requires a heavy dose of wishful thinking, however, and should be taken with a grain of salt. Research from Harvard Business School shows that federal spending in states causes local businesses to cut back rather than to grow. In other words, more government spending causes the private sector to shrink, the exact opposite of the intended result.

Veronique de Rugy

About Veronique de Rugy Senior Research Fellow with the Mercatus Center at George Mason University

Tags
economic stimulus

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#2
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#3
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Yes – Government Spending is Just What Our Economy Needs

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