President Obama recently signed the American Recovery and Reinvestment Act into law, authorizing $787 billion of federal expenditures and tax cuts, mostly over the next three years. This comes on the heels of a bailout for the automobile industry and the $700 billion authorization for the Troubled Assets Relief Program (TARP). The president just proposed a housing and mortgage bill that would appropriate another $275 billion. The House will consider a $410 billion omnibus budget bill, and we face the prospect of more legislation regarding the financial sector that Treasury Secretary Geithner indicates will require roughly $2 trillion of federal commitments. The White House recently released a budget proposal reflecting these initiates.
Thus, we seem well on our way to ramping up federal spending and involvement in our economy and our lives. Given the resources at stake for us citizens, it is sensible that we have reasonable assurances it will work.
Unfortunately, my view is that these efforts will not be effective. Root causes of the recession are not appropriately addressed, and the present initiatives have great potential for politicizing spending and investment, leading to boondoggle-type projects. The regrettable result will be a slower recovery and reduced long-term economic growth.
Regardless of your view of its desirability, the scale of government in the economy is rising. The following table illustrates this. Row one shows U.S. economy averages for 1977 to 2007. During this time, federal government spending averaged 20.9 percent of all spending in the economy and the budget deficit averaged 2.5 percent of GDP. During fiscal 2008 (row two), federal spending was at the 30-year average of 20.9 percent of GDP, and the deficit was somewhat higher than its average at 3.2 percent.
For decades, the federal presence in the economy has been quite large, directing about one-fifth of our resources. Yet this presence will become even larger.
Row three shows the Congressional Budget Office (CBO) 2009 forecast under outgoing President Bush. This budget entails a large increase in federal spending, rising to nearly one-fourth of GDP and the deficit more than doubling to 8.3 percent of GDP. These are figures not seen since the tail of military spending in 1946 during the aftermath of World War II. And yet this does not reflect any Obama administration programs.
Row four of the table shows spending figures inclusive of CBO’s forecast regarding stimulus spending. Of the $787 billion stimulus package, CBO estimates $120.1 billion will be spent in fiscal 2009 and, with tax cuts, $184.9 billion added to the deficit. Thus, spending and deficit figures as shares of GDP are 25.7 percent and 9.6 percent; slightly higher than Bush’s budget. However, with the administration’s current budget proposal, it seems likely there will be more deficit spending this year.
Row five shows the spending figures for the President’s budget proposal for 2009. If enacted as proposed, this would raise spending and the deficit as shares of GDP to 27.7 percent and 12.3 percent. Part of this sharp rise is due to the stimulus spending, which is intended to be temporary. However, even is fiscal 2010, the administration’s forecast is for spending to be over 24 percent of GDP and the deficit 8 percent.
The final column of the table shows the percent increase in total forecasted federal spending in each of the scenerios compared to 2008. If the Obama administration had done nothing, we would have had the Bush budget increase of 19 percent. It looks as though a 32 percent increase in federal spending is likely.
The Keynesian approach
Under Keynesian thinking, this rise in deficit spending is exactly what is needed. The argument is that uncertainty in the economic environment leads households to be cautious and reduce consumption. Reduced consumption generally leads to more saving, then loaned to firms for investment. But firms are presently unsure where to invest due to the uncertainty they face, so investment spending is stagnant. The result is reduced production and employment. The Keynesian prescription is for government to fill this void by purchasing more goods and services, thereby employing people in making the goods and services that government acquires.
While this sounds clear, there are straightforward reasons why it will not work as just described. Deficit spending implies the government sells bonds to make its purchases. Those buying the bonds thus have less money to purchase goods and services. It is implausible that bond purchases will not reduce consumption of bond buyers. So there is increased consumption by government, but reduced consumption by the public. The net effect is likely to be small, implying little new production and employment.
Additionally, individuals and firms actively seek to resolve the uncertainty they face and change their behavior accordingly; consumption, production, prices and wages adjust, and as they do so GDP and employment move toward their normal levels. By the time government spending occurs, the economy is likely to be on its way to recovery, and we are simply substituting government-directed spending and employment for that of the private sector.
The boondoggle factor
With such a large-scale substitution of government for private activity, there looms tremendous potential for boondoggle and politicized spending. Much of the stimulus bill spending is for federal buildings, roads, Internet and computerization projects, green initiatives and a host of other programs. Many sound like good projects, but which are really good and which are just plain pork? Pork does not promote our economic well being; it is unhelpful to employ people producing things nobody really wants. An advantage of private sector spending is that for projects to be successful, there has to be an end product people will pay for. This makes it much more likely that only good projects are funded. Government does not have such sharp incentives.
The sheer size and rapidity of its formation makes these comments apply with greater force to the present stimulus package. How does one carefully plan for $787 billion of new spending – roughly one quarter the size of the present federal government – in one month? It is clear no benefit-cost analysis was done for most projects. Despite public officials’ assurances that wasteful projects will be avoided, this process is a virtual guarantee that much of the funding will go to politically expedient projects rather than creating real value. The result is low productivity and negligible economic growth. The reported 9,000 earmarks in the omnibus budget bill is a harsh reminder of this likelihood.
There are good policy alternatives that lead away from the unfortunate outcomes described above. Given the passage of the stimulus bill and the direction of other proposals, these alternatives are perhaps moot. Nevertheless, they are worth discussing.
I favor two broad and interrelated policy themes. Both involve minimal government spending and seek to embrace and reinvigorate the private sector.
One theme is for government to seek to reduce economic uncertainty.
Government has no magic wand to wave, but it can reduce uncertainty it causes itself. A second theme is for policy to focus on the issues that led to the recession and on more tried-and-true methods to deal with them. This refers to problems in the mortgage, housing and financial markets.
Significant uncertainties remain about government actions regarding the automobile industry, mortgage and housing markets, and the financial sector.
Bank nationalization is even being discussed. These uncertainties curtail investment and lending activity. It is imprudent to make investment plans until one knows how or whether the government will regulate it, guarantee it, fund it, subsidize it, tax it or otherwise affect it. This hesitancy slows the economic recovery. Thus, it is important these government policy uncertainties be resolved – and in a sensible way. If, for example, the government increases its stock holding in banks, this may resolve some uncertainty but still suppress investment. Pressure by government stock holder to fund politically correct but low-value projects lowers the return on investment, reduces lending to banks and shrinks overall economic growth.
Stimulus entirely off base
One fundamental cause of the present recession is rapid expansion of the subprime mortgage market and its subsequent collapse. The growth of this lending activity was catalyzed by its embrace by Fannie Mae and Freddie Mac and the push by federal agencies for financial institutions to adopt “flexible underwriting standards.” The result, however, was to reward financial firms for writing unwise, high-risk mortgages that relied entirely on housing price appreciation. These mortgages were securitized, sold and dispersed to financial institutions around the world. When housing price increases did not materialize, the resulting collapse followed.
Dealing with this underlying set of problems does not suggest the need for fiscal stimulus to fund road resurfacing, federal building and school renovation, electronic health care records, Internet connectivity and aid to local governments. On this score, the stimulus is entirely off base. Yet other policy proposals put forth deal with mortgage and financial market issues that typically include government guaranteed and/or subsidized lending for homes, autos and other consumer borrowing, and capital injections into banks to encourage these.
This is exactly the type of policy that got us into this mess and should be discarded.
This leaves us with the alternative of de-politicizing markets by relying on the private sector, with regulation only to improve information and transparency, prevent fraud and encourage honest evaluation of risk. This is not a bad alternative. At this juncture, this means firms dealing with bad debt on their books, either by renegotiation, reorganization, mergers or bankruptcy, then moving on to identifying and funding value-creating investments, and not being induced to undertake politically correct misadventures. These renegotiations include mortgage modifications so that foreclosures can be avoided. Because of the large volume of contract renegotiations that needs to take place, government can play a facilitating role but shouldn’t dictate their terms. The government funds needed for this assistance is orders of magnitude less than present initiatives.
Bankruptcy, contract renegotiation, mortgage modification and their supporting institutions have been deep within our culture for generations and have proven to work reasonably well in dealing with people’s crises. There is no need to move into uncharted territory of unprecedented deficit spending and government control of financial markets to deal with the current troubles.
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