In Hoisington's Second Quarter Review (not yet posted online), Lacy Hunt takes on the widespread Keynesian belief that government spending boosts real (inflation adjusted) GDP.
Hunt states the multiplier is negative over time and short-term gains are an illusion. Here are a few key snips from an excellent report.
Deficit Spending Restrains Economic Growth
Negative multiplier. The government expenditure multiplier is negative. Based on academic research, the best evidence suggests the multiplier is -0.01, which means that an additional dollar of deficit spending will reduce private GDP by $1.01, resulting in a one-cent decline in real GDP. The deficit spending provides a transitory boost to economic activity, but the initial effect is more than reversed in time. Within no more than three years the economy is worse off on a net basis, with the lagged effects outweighing the initial positive benefit.
More negative. Although only minimally negative at present, the multiplier is likely to become more negative over time since mandatory components of the government spending will control an ever-increasing share of budget outlays. These outlays have larger negative multipliers. In 2015, the composition of federal outlays was 68.3% mandatory and 31.7% discretionary; the composition was almost the exact opposite in 1962, around the time this data series originated (Chart 1). Mandatory spending includes Social Security, Medicare, veteran's benefits and the Affordable Care Act. All of these programs are politically popular and conceptually may be highly laudatory. However, federal borrowing to sustain these programs does not generate an income stream for the economy as a whole to pay for these programs. As history has evidenced, the continual taking on of this kind of debt will eventually cause bankruptcy.
Due to the aging of America, the mandatory components of federal spending will accelerate sharply over the next decade, causing government outlays as a percent of economic activity to move higher.
The rising unfunded discretionary and mandatory federal spending will increase the size of the federal sector, which according to first-rate econometric evidence will contract economic activity. Two Swedish econometricians (Andreas Bergh and Magnus Henrekson, The Journal of Economic Surveys (2011)), substantiate that there is a "significant negative correlation" between the size of government and economic growth. Specifically, "an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate." This suggests that if spending increases, the government expenditure multiplier will become more negative over time, serving to confound even more dramatically the policy establishment and the public at large, both of whom appear ready to support increased, but unfunded, federal outlays.
Deleterious Levels. Federal debt has subtracted, to at least some degree, from U.S. economic growth since about 1989 when debt broke above 50% of GDP, a level to which this ratio has never returned (Chart 2). The macro consequences of the debt are becoming increasingly significant. This may seem surprising to many because of confusion about the scholarly work of Carmen Reinhardt and Kenneth Rogoff (R&R) in their 2009 book, This Time is Different.
The misinterpretations pertain to a key point in R&R's book and accusations of data inaccuracies in the statistical calculations. R&R said debt induced panics run their course in six to ten years, with an average of eight years. The last panic was in 2008, so according to their early work the time span has either ended, or is close to ending. However, the six to ten year time reference does not apply when debt levels continue to move higher over that time period. In the latest quarter, gross federal debt was 105.7% of GDP, compared to 73.5% in the final quarter of the 2008 panic.
Government Spending and GDP
The formula for GDP is: Y = C + I + G + (X − M).
GDP (Y) is the sum of consumption (C), investment (I), government spending (G) and net exports (X - M).
By definition, government spending adds to GDP, no matter how ridiculous the expenditure. If the government paid people to spit at the moon, it would add to GDP.
But the long term consequences of such ridiculousness should be obvious.
Japan is proof enough. The country has nothing but massive amounts of debt and slow growth to show for decades of building bridges to nowhere.
Space Aliens to the Rescue
Let's assume for a second there is dangerous dearth of consumer demand and inflation is too low. What should we do about it?
In a 2011 CNN interview video Paul Krugman proposed Space Aliens Could Fix the Economy.
Krugman: "It's very hard to get inflation in a depressed economy. But if you had a program of government spending plus an expansionary policy by the Fed, you could get that. If we discovered that space aliens were planning to attack, and we needed a massive buildup to counter the space alien threat, and inflation and budget consideration took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops we made a mistake ... There was a Twilight Zone episode like this in which scientists faked an alien threat in order to produce world peace. This time we need to ignore it to get some fiscal stimulus."
Apparently, if we fake a space alien threat, then we can create inflation and save the world from the alleged evils of falling prices and insufficient consumer demand.
Seen and Unseen
No doubt we would see a huge jump in GDP if we fought the space aliens (real or imaginary). Then what?
Because the long-term effect of foolishly taking on totally unproductive debt is negative, Keynesian economists would demand more and more fiscal stimulus, just as Krugman does perpetually!
The "seen" of fighting space aliens would be a short-term boost to GDP. The "unseen" is the long-term net subtraction to growth that Keynesian economists never take into consideration.
The trap is listening to Keynesian economists like Krugman because doing so only digs deeper and deeper debt holes.
The real solution is a writedown of unproductive debt, not increased fiscal stimulus.
Instead central banks attempt to cram more and more debt into a system clearly overloaded with debt.
Economic Challenge to Keynesians
Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them.
I have commented on this many times and have been vindicated not only by sound economic theory but also by actual historical examples.
My post Deflation Bonanza! (And the Fool's Mission to Stop It) has a good synopsis.
And my Challenge to Keynesians "Prove Rising Prices Provide an Overall Economic Benefit" has gone unanswered.
In their attempts to fight routine consumer price deflation, central bankers create very destructive asset bubbles that eventually collapse, setting off what they should fear - asset bubble deflations following a buildup of bank credit on inflated assets.
It's asset deflation not CPI deflation that central banks ought to fear. Even the BIS agrees with that statement.
For discussion please see Historical Perspective on CPI Deflations: How Damaging are They?
Yet Keynesian economists and central banks alike remain united in their self-destructive goal of producing inflation.
The results speak for themselves: booms and busts of increasing amplitude over time.