How spending stimulates

Will the Obama deficit-spending plan work? Will throwing $800 billion—$500 billion in extra government spending, and $300 billion in tax cuts—at the economy produce a world in which production and employment are higher and unemployment lower than would otherwise have been the case?

The short answer is yes. The short reason is that spending works—eras in which some group or other gets excited about future prospects and starts madly spending money are eras in which production and employment are high and unemployment is low. And the government, in this respect, is just like any other group of starry-eyed optimists whose eagerness to spend pulls the economy into a high-employment, high-pressure boom.

Consider the engines of previous boosts to production and employment. Between 2003 and 2005 the assembled investors of the world discovered the American housing market. Low interest rates produced by the Federal Reserve allowed them to borrow and leverage up cheaply—and the promise of financial engineering that would greatly help them diversify risk made them think investing in new construction and new homeowners’ moves into new construction was a profit opportunity. Spending on home construction rose. And the adult civilian employment to population ratio rose from 62 percent to 63.5 percent while the unemployment rate fell from 6.0 percent to 4.8 percent.

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Between 1996 and 1998 the assembled investors of America discovered the Internet and spent enormous sums to exploit and expand it. And the adult civilian employment to population ratio rose from 63 percent to nearly 65 percent as the unemployment rate fell 5.6 percent to 4.3 percent. In August, 1982, Paul Volcker’s Federal Reserve released the interest-rate chokehold it had been using to strangle the economy. Lower interest rates induced homebuilders to spend massively, since for the first time in nearly half a decade they could obtain financing for construction. At the same time, the Reagan administration ramped up defense spending for the second cold war, and luxury spending rose as the Reagan tax cuts gave money back to America’s rich. The adult employment-to-population ratio rocketed up from 57.2 percent to 59.9 percent in the short order of two years while the unemployment rate fell from 10.8 percent to 7.3 percent.

These are just three examples of a general principle: each major business-cycle expansion we have seen has been driven by a leading wave of spending—by some group that became enthusiastic about their prospects and decided to greatly increase its spending. And that pulled employment and production up.

Now we are attempting to do the same thing once again—but this time with the government as the leading spender. Obama’s stimulus spending increases are bigger, as a share of the economy, than Reagan’s defense increases were, while Obama’s tax cuts are smaller. Unlike 1983, when the Fed cut interest rates to help Reagan’s economic recovery, it cannot do so to help Obama. The Fed has done all the cutting it can.

Still, a boost to spending by the government should have the same effects as boosts to spending by luxury consumers and the defense department and homebuilders in the early 1980s, by the high-tech sector in the late 1990s, and by homebuilders in the mid-2000s. The government’s money, after all, is as good as anybody else’s.

So there is little question about the likely impact of the Obama deficit-spending program: production and employment are going to be higher than they would have been otherwise. As Greg Mankiw, the former chief economic adviser to George W. Bush, said back in 1983: “There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks.”

But there is a relevant question outstanding: Will there be some sort of a hangover after this Obama spending binge—some debt-induced, groggy morning after? And if there is a hangover how bad will it be? For the answer to that, we will have to wait and see.