Remember stimulus spending? That’s the stuff that the government is supposed to come up with when the economy goes into recession. The idea is that since government expenditures are one part of overall economic output, when private activity wanes, aggregate output, or “GDP” can be maintained.
It’s intriguing as a theory, perhaps, but in practice it doesn’t work. From 2007 to 2009, inflation-adjusted federal spending went up by a staggering number, 24%. In 2007, we had a big government. By 2009, we had a big government and then some. Yet the recession was severe from 2007 to 2009, the worst since the Great Depression, as we’re always told.
Given this record, it makes you wonder if stimulus spending, or “Keynesianism” or “countercyclical fiscal policy,” as it can go by in professional circles, really has any claim to validity. A 24% further encroachment by our big government couldn’t take the Great out of the Great Recession.
One of the major elucidations of modern economics was the resuscitation, in 1974, of a classical concept called “Ricardian equivalence.” In work that will one day surely win him the Nobel Prize, Harvard’s Robert Barro explained that deficit spending makes people assume that they will be taxed more in the future. Therefore, if governments address recessions by means of deficits, the private sector will respond by shrinking all the more, as earners put away money to cover the inevitable bill from the IRS.
Barro’s analysis was an “Exocet aimed at the heart of the Keynesian universe,” as Wall Street Journal editor Robert L. Bartley wrote (invoking the scary French missile) in his memoir of those years. Today, Ricardian equivalence—between taxes assessed now and those implied by deficits—has proven a useful means of comprehending what happened to us during that 24% government-expenditure increase that came coupled with a harrowing real-sector contraction.
Here in March 2013, policy is different. Government spending is set to go down. The sequester is taking effect, requiring yearly 2% reductions (if against an artificially high baseline), starting now.
Historically, spending limitations have preceded wonderful things in the economy. In 1983, federal outlays, which had been increasing for a dozen years at well over the rate of economic growth, peaked, and then crawled ahead for the next five years at half the rate of economic growth. Next came a spending interregnum. But in the six years following 1992, real outlays increased at only one-fifth the rate of economic growth.
The years after 1983, and after 1992, are, of course, major golden ages in modern American economic history, just as the stagflation years of 1969-82 and the recessionary early 1990s were flops. When government spending increases were seriously fractional against economic growth in the 1980s and 1990s, that growth was 4% or higher, goods and services (and commodities) were inexpensive, unemployment was structural, and opportunity abounded.
Ricardian equivalence puts theory behind this practice. Tax cuts are nice, but spending cuts are nicer. For where tax cuts imply greater room for the real sector to operate, spending cuts all but guarantee it.
Curiously, the stock market (at least the Dow industrials) just now is merging with an all-time high. Throwing a damper on it last week, the investing savant Stanley Druckenmiller said that we should not misinterpret the current market as having shades of 1982.
Why bring up 1982? That was a year in which the market in five months rose 30% off a secular low. That low itself was clear of the recessionary bottom of the stagflation period (hit in 1974) by 35%. At a glance, 2013’s market is uncannily similar. Dow 14,000 is 30% above the low of five months ago, which itself was about 60% above the bottom hit in 2009. You can basically overlay the patterns.
Druckenmiller said that if you want a repeat of what happened after 1982, following that initial 30% gain, don’t bank on it. He referred of course to the greatest bull market of modern times. From the beginning of 1983 all the way to 2000 (and pretty consistently), stocks went up 1,100%, or 14% compounded per year. Incredible stuff.
Were there tax cuts? Sort of. The marginal rate went down, then partially up, and the capital-gains rate did the reverse. But spending went down, down, down. The only time it didn’t—1989-92—represented the only pause in the phenomenal economic run of 1982-2000 that resulted in 30 million new jobs and the tech revolution.
Druckenmiller justified his point by saying that there’s a lot of new spending baked in the cake, namely the entitlements explosion that’s set to come with the retiring the baby boomers. But you can’t gainsay that market optimism too much. Enormous spending blowouts have been with us since the late 1990s. If the federal government catches some modesty when it comes to outlaying other people’s money, or even tricks itself into some restraint as in the sequester, this economy will roar.
Books mentioned in this essay are available from The Imaginative Conservative Bookstore. Originally published at Forbes.com the essay is reprinted here with gracious permission of Brian Domitrovic.