Can Government Spend Us Into Prosperity--Evaluating Keynes

New Yorker magazine economics writer John Cassidy defends the father of orthodox macroeconomics, John Maynard Keynes, in The Demand Doctor, (The New Yorker, October 10, 2011, link here). As an AP Macroeconomics teacher, I can confidently state that I and all other AP Macroecon instructors teach Keynesian theory. That is, we show how society benefits from creating "aggregate demand." Governments manufacture aggregate demand by cobbling together large public works projects or, less directly and less powerfully, giving money back to the people in the manner of tax cuts. Despite my or perhaps because of my familiarity with the theory of aggregate demand, a month before Cassidy's article was published I predicted Obama's Keynesian stimulus would fail (link here). Keynes' method of attacking unemployment through public works projects is more controversial than ever. Conservatives blame the Obama stimulus for the worst stretch of unemployment since the Great Depression: 54 months of unemployment at 7.5% or worse (link here), and only 47% of Americans have full-time jobs.

If today the same proportion of Americans worked as just a decade ago, there would be almost 9 million more people working. Just in the last year, almost 2 million Americans have left the labor force. With a majority of the population not holding a full-time job, it isn't surprising that economic growth has been so weak.  In June, the number of Americans who wanted to work full-time, but were forced into part-time jobs because of the economy, jumped 352,000 to over 8 million.(Mike Flynn, Breitbart.com, link here)

Liberals argue that Obama's stimulus was a success. If the government had not intervened, we would have entered another Great Depression. This argument fails to persuade me, since it can never be proven one way or another. We cannot go back in time and try a laissez-faire policy, though an uninterested federal government allowed the economy to work itself right out of depressions (or "panics" as they were called) throughout the 19th century. Liberals and Keynesians employ a much better argument by examining the size of the stimulus package. Cassidy writes

He would also have noted that the stimulus was—especially compared with the devastation it meant to address—rather small: equivalent to less than two per cent of G.D.P. a year for three years. Even this overstates its magnitude, given that much of the increase in federal spending was offset by budget cuts at the state and local levels. In its totality, government spending didn’t increase much at all. Between 2007 and the first half of this year [2011], it rose by about three per cent in real dollars.

In other words, the biggest Keynesian spending project ever, worth $825 billion, was too small. We should have spent more than a trillion dollars. Economist Larry Summers calls for another trillion on infrastructure (source here). I wonder if those that advocate for such things figure what might happen if we had a national debt that was even bigger than $16 trillion and what that might do to the economy. According to writer Bill Bonner, even "if America taxed 100 percent of all household wealth, it would not be enough to put its balance sheet in the black" (link here). (Well, never mind; an extra trillion dollar stimulus didn't happen and probably won't any time soon.)

Economist Larry Summers worries about unemployment. If only the stimulus of 2009 was bigger or he could do it twice

Source: New York Times

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What else went wrong?Cassidy also argues that the government needed to solve the banking and housing problems. "Following the crisis of 2008, both the Bush and the Obama Administrations moved promptly to shore up the banking system, but they neglected to deal with the housing debacle."

I think these excuses are poor, and the culprit can be found elsewhere. The Obama stimulus failed. (The president promised six percent unemployment by 2012 and a reduction of poverty.)  Why didn't it work? The answer may have more to do with a faulty tenet of Keynesian theory--the multiplier. Cassidy writes

a recent working paper published by the National Bureau of Economic Research looked at data going back to 1980 and found that government investments in infrastructure and civic projects had a multiplier of 1.8—pretty close to Keynes’s estimate [of two].

Well, maybe not. Cassidy discards the research of Robert Barro, saying his work doesn't apply in a recession.

Echoing the arguments that Keynes’s opponents at the Treasury made during the nineteen-thirties, conservative economists like Robert Barro, at Harvard, argue that it [the muiltiplier] is close to zero: for every dollar the government borrows and spends, spending elsewhere in the economy falls by almost the same amount. Whenever individuals see the government boosting spending or cutting taxes on a temporary basis, Barro maintains, they figure that these policies will eventually have to be paid for in the form of higher taxes. As a result, they set aside extra money in savings, which cancels out the stimulus.

Equally powerful is the work of  Stanford and German professors Cogan et al (link here) in their article New Keynesian versus Old Keynesian Government Spending Multipliers, which argues that old Keynsian  models used multipliers that were six times too high. Spending projects lower unemployment much less than was previously believed.

Unemployment is Worse than Reported

Part of my job as an AP Macroeconomics teacher is to interpret employment statistics. Unemployment declined from 9 percent to 8.6 percent in November of 2011. Is that a good thing? In this case, no. The government does not count people who have given up and are no longer looking for work. Many gave up last month (more than 300,000 as reported by most media outlets), and that is the major reason why the percent of unemployed decreased.

Here is a quote from the Bureau of Labor Statistics' (BLS) report: 

In November, 2.6 million persons were marginally attached to the labor force, about the same as a year earlier (italics, mine)....  These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey. 

I am not a pessimist. We will eventually reach our natural rate of unemployment, around 4.5-5%. But we are not creating enough jobs yet. We need to create around 150,000 jobs just to keep up with natural population growth and keep unemployment from going up.  Both government and private sector jobs need to be part of the mix. According to the  BLS

Economists sometimes refer to the "trend growth rate of employment"—the number of jobs that must be added each month to keep pace with population growth and changing trends in labor force participation. Common "rule-of-thumb" estimates of trend growth currently put the figure at 150,000 jobs per month. This means that over-the-month changes in payroll employment exceeding 150,000 generally are interpreted as strong job growth, while smaller increases are seen as weak job growth.

So what happened in November? The private sector added 140,000 positions in November, but government cut 20,000 positions. Therefore the United States added 120,000 jobs in November, only enough to tread water.  The BLS states:

Government employment continued to trend down in November, with a decline in the U.S. Postal Service (-5,000). Employment in both state government and local government has been trending down since the second half of 2008.

Even if government had cut no jobs, 140,000 is not enough growth to make much of a dent in unemployment figures. The recovery from the Great Recession of 2008 has been atypical. We used to see much more robust growth after a recession, around 300,000 jobs created each month, 1.25 million for a quarter. See http://bls.gov/opub/mlr/1984/08/art1full.pdf  So don't pop the champagne corks just yet. The employment news is barely adequate. By the way, the actual rate is probably closer to 11 percent. I don't foresee much improvement without an increase in consumer spending, currently hitting new lows.

Postscript: The December 2011 figures were much better, with around 200,000 jobs created. However, the second quarter 2012 figures were subpar, and it seems, in August of 2012, that we are again averaging around 150,000, not good enough to meaningfully change unemployment. See also Mish's excellent economic blog here.

Obama's New Government Stimulus Bill--Will it Work?

My AP economics students ask me why the government has been unsuccessful in getting America back to work. I have written on the inefficiency of the Obama stimulus package here and on the efficacy of Keynesian programs (aka The New Deal) during the Great Depression here. Since government make-work programs did not cure long-term unemployment in the 1930s, and, in fact, prolonged the Great Depression, I was confidant Obama's $825 billion stimulus would not lower long-term unemployment this time either. The tax money has to come from somewhere. Peter (rich tax payers) must be robbed to pay Paul (recipients of government programs), and then Peter has less money to support our consumer-driven economy. The Wall Street Journal,  in it's September 8, 2011 issue, showed how much of the $825 billion stimulus money was poorly spent and often outright wasted. The article, titled Why the Stimulus Failed, reviewed "a pair of new Mercatus Center working papers by the George Mason economists Garett Jones and Daniel Rothschild, who did field research on what they call the supply side of the stimulus." The economists found that the stimulus money was earmarked for items the recipients did not need and had little bearing on job creation. Secondly, "Jones and Rothschild estimate that merely 42.1% of the firms that received grants hired people who were unemployed. Instead, they poached workers from their competitors." No wonder unemployment remained high.

Instead of $250 billion of new spending that the Obama administration currently proposes (out of a $500 billion jobs bill), the Wall Street journal recommends "incentives for people and businesses to invest, produce and grow." The greatest incentive we can offer is letting men and women keep more of the money they earn. If we have less wasteful government programs we can enjoy the blessings and incentives of less taxation.