By Niles K. Chura and Wayne Winegarden, Ph.D.[i]
In the spirit of Jimmy Carter, “an economic malaise plagues the country”. Rather than being the product of a fundamental flaw in our economic system, though, the current stagnation is mainly the result of the nation’s misguided economic policies.
The federal government’s response to the financial crisis of 2008 was to massively increase the government’s role in the economy, which included huge increases in spending based on a misguided demand-side belief in economic stimulus. Americans were promised that the unprecedented spending spree, financed with over $5 trillion of new debt (deficits peaked at nearly 11% of Gross Domestic Product, GDP),was supposed to yield robust and sustainable economic growth. Instead, one of the weakest post-recession recoveries since the Great Depression has ensued.
These demand-based economic stimulus programs fail to consider several basic financial concepts, which consistently lead policy makers to overestimate the efficacy of expansionary fiscal policy. Once these concepts are incorporated into policy analysis it becomes clear why sub-par economic growth is the expected result from the past (and any future) stimulus policies.
Government expenditures must be justified based on their potential return to society as compared to their alternative uses if left in the private sector, regardless of the phase of the business cycle.Government spending is accretive or destructive to national wealth based on the purposes of the spending. In theory, when government spending focuses on the right type and amount of public goods and services, government spending is beneficial to economic growth. When government spending goes beyond these value-added roles, it becomes destructive to economic growth.
Practically speaking, due to the relative size and composition of the federal budget, the most likely consequence from any increased fiscal expenditures is destroyed economic value because the government has:
- A lower “cost of capital”. By definition, the federal government borrows at the “risk-free” rate that is lower than the interest rate private sector borrowers must pay. As a result, the government can (and often will) invest in projects whose economic value is too low.
- No “opportunity cost”. The government does not have to prioritize projects based on their expected relative economic value. Consequently,the government is able to pursue more lower-yielding project seven when other higher-yielding projects are available. The combination of a lower cost of capital and no opportunity cost constraint increases the likelihood that government resources will be devoted to lower-valued projects compared to the private sector.
- No profit motive. The lack of profit motive for the government accentuates the incentives for poor project prioritization, and also lowers the incentive to increase productivity. The lack of profit motive, consequently, lowers the rate-of-return expectations for government projects even further.
- Diminishing returns. The increase in funds allocated for government projects results, by definition, in more projects. Consequently, even if the projects are necessary or effective, the value of each additional government program declines.
Due to these reasons, the current sub-par economic growth has become the new normal. The centrally-directed stimulus spending has lowered the potential growth rate of the U.S. economy and thus created – what we term – a Policy Value Gap.
Instead of focusing on aggregate demand replacement, policymakers should view government stimulus spending from an economic return perspective that focuses on the potential value created by government spending versus the potential value created by private spending. Such a perspective clearly shows that the economic stimulus failed because it diverted money from its alternative uses to fund initiatives with a low or negative value (e.g., “cash for clunkers”, payroll tax holidays, and increased transfer payment expenditures).
The slowdown in business investment compared to business saving is an excellent example of the adverse consequences from the increased government spending. Based on data from the National Income and Product Accounts, (NIPA), total gross business investment relative to gross business savings has fallen to post WWII lows following the unprecedented increase in government spending – businesses are struggling to find profitable investment projects. If the aggregate demand theories of government stimulus were correct, however, the exact opposite would be occurring – increased aggregate demand would ultimately create increased investment opportunities.
A collapse in business investment following an aggressive increase in government spending is consistent with an analytical framework that focuses on added value, not aggregate demand. Business investment has collapsed because resources are being devoted to lower-valued uses which create fewer investment opportunities.
A look at history since the late 1950s demonstrates the point. There are four distinct periods to evaluate – two when the government’s role in the economy accelerated, and two when it was less active. Comparing the economic results during these periods reveals an inverse relationship between high and/or rising total government spending and the private economy’s growth rate.
During the two periods when total government expenditures relative to the size of the private sector were either low or falling, (1958 – 1966 and 1983 -2000) the average annual growth rate in business income was approximately 4 percent. In the two periods where the government spending burden was high or growing, (1967 – 1982 and 2000 through today) the average annual growth rate in business income was around 2 percent. These results even hold if you end the analysis in 2007, which remove the impacts from the Great Recession. In short, the empirical experience shows that growth in the size of government comes at the expense of growth in the private economy.
Rising government spending reduces the growth in the private economy because the economic return for an incremental dollar of government spending is necessarily less than the economic return of that spending if it were left in the private economy. We label the total loss of potential growth to society as the “Policy Value Gap” because the growth gap is caused by misguided government policies
Given the persistent weakness in the U.S. economy, a re-evaluation of fiscal policy theory is warranted. Effective fiscal policy must incorporate basic financial concepts, such as opportunity costs and economic return. Doing so will lead to a more sound policy making environment and a more sustainable and robust economic environment.
Niles Chura is the Founder of Ouray, LLC and Chief Investment Officer of Ouray Capital, LLC. Wayne Winegarden, Ph.D. is a Partner in the economic consulting firm, Arduin, Laffer & Moore Econometrics, a Senior Fellow with Pacific Research Institute, and a contributor to EconoSTATS at George Mason University. This article is based on a longer paper by the authors that can be found at: ssrn.com/abstract=2127328 .