Posted by: mulrickillion | January 31, 2012

Reducing Real Output by Increasing Federal Spending

By Dwight R. Lee, Library of Economics and Liberty, Jan 2, 2012 —

The belief that by spending more, the federal government can revive the economy by increasing aggregate demand is an example of the triumph of hope over experience. Many people excuse the recent failures of such stimulus spending with the claim that the spending simply wasn’t large enough. This demand-side view is oblivious to the supply-side reality that demanding more does no good unless more has been, or will be, produced. The logic of this reality explains why trying to increase aggregate demand through increased federal spending is not the key to stimulating the economy. The problem is not that aggregate demand is unimportant—it is very important. The problem is that increased real aggregate demand is the result, not the cause, of an increasingly productive and prosperous economy.

The historical evidence clearly shows that very little government spending is necessary for growing prosperity. From the founding of the United States until the early 1930s, the federal government’s budget averaged only around three percent of the nation’s GDP, which was about half the spending of state and local governments. The federal budget was not balanced every year, but revenues and expenditures were closely balanced over the whole time period. Federal spending and budget deficits increased during wars, but the resulting debt was largely paid off with peacetime budget surpluses. For 28 straight years after the Civil War, for example, the federal budget was in surplus, with the Civil War debt greatly reduced, though not completely eliminated, by 1893.

During most of these 28 years, the economy was expanding, unemployment was low, and real wages were increasing and, by the early 1900s, America had become the world’s richest nation. There were economic downturns beginning in 1873 and 1893, but the federal government did little to respond to them. The 1893 downturn caused a federal budget deficit, but the deficit was caused almost entirely by decreased tax revenues rather than increased federal spending. The recovery from these downturns occurred in response to market forces, with neither downturn lasting nearly as long as the Great Depression of the 1930s. This shows that while market economies experience occasional recessions, they can recover—and have recovered and continued growing—without the Keynesian prescription of increased government spending and budget deficits.

This does not mean that federal spending was irrelevant to our early economic success. Most of the federal budget in the 19th century went for such things as national defense, infrastructure, law enforcement, and establishing standards on weights and measures. This spending created a setting in which the power of private enterprise and entrepreneurship could produce wealth. . . .

Dwight R. Lee, Reducing Real Output by Increasing Federal Spending | Library of Economics and Liberty

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