President Obama’s so-called stimulus is a dark cloud for the American economy. It will increase the burden of government spending by nearly $800 billion over a ten-year time period. At least that is what we are told. But if you include interest on all the additional debt, the cost will rise to more than $1 trillion. And if you realistically assume that the supposedly temporary spending increases will become permanent, then the cost climbs to around $3 trillion.
To make matters even worse, all this new spending will be added to the “baseline” growth of government. According to the Congressional Budget Office, the pre-stimulus federal budget was projected to climb from $3.54 trillion this year to $4.74 trillion ten years from now. Thanks to all the new spending just enacted, a more realistic guess is that spending will top the $5 trillion mark by 2019.
Obama promised change in Washington, but making government bigger is hardly a new path since spending other people’s money is the favorite pastime of the inside-the-beltway crowd. The Bush administration, for instance, expanded the federal government from $1.86 trillion in 2001 to $3.54 trillion in 2009 (and the majority of the new spending was for non-defense purposes). Now Obama has grabbed the baton and is racing in the same direction.
This ongoing expansion of government has important implications for short-term and long-term economic performance. Much of the recent debate about fiscal policy has focused on the “Keynesian” assertion that more spending somehow increases economic growth in the short run. This is an important discussion, but it is perhaps even more vital to focus on the long-run economic effect of bigger government (interested parties can click here for an explanation of why Keynesianism is misguided and here for a critique of Obama’s so-called stimulus).
Before jumping into the long-run discussion, it is worth noting that it is quite possible to be a Keynesian who believes in small government. Indeed, that seems to have been the view of John Maynard Keynes. Writing to another British economist in the 1940s, Keynes identified “25 percent [of GDP] as the maximum tolerable proportion of taxation.” Small-government Keynesians are on the endangered species list in Washington, however, if not already extinct. The politicians who voted for the so-called stimulus are the same ones who routinely vote for permanently larger government.
This is very worrisome since the size of government has a significant impact on economic performance, and the evidence shows that government spending in the United States is too large. Just as there is a Laffer Curve that shows a relationship between tax rates, taxable income, and tax revenue, there is a Rahn Curve that shows the relationship between government spending and economic performance. Outlays for “public goods” such as rule of law and protection of property rights help a market economy function. Spending on human and physical capital, within limits, also can increase an economy’s productive capacity. As such, the Rahn Curve shows that government spending, assuming it is modest and allocated wisely, is associated with better economic performance.
But just as the Laffer Curve shows that tax rates can become prohibitive, the Rahn Curve shows that government spending can become excessive. The empirical research indicates that economic growth begins to suffer when government spending climbs above 20 percent of economic output, though it is quite likely that this overstates the growth-maximizing level of government. Researchers are hampered by the fact that governments in all developed jurisdictions, other than Hong Kong, now spend much more than 20 percent of GDP. Historical data, by contrast, suggests smaller levels of government are more conducive to growth. It is worth noting, for instance, that governments in the United States and Western Europe consumed on average less than 10 percent of GDP during the “Golden Century” of rapid growth between the Napoleonic wars and World War I.
Unfortunately, the debate about whether government should consume 10 percent of GDP or 20 percent of GDP is an academic exercise at this point. The burden of government spending in the United States is now far above the growth-maximizing level, regardless of how it is measured. Including what takes place at the state and local level, government spending consumes nearly 40 percent of gross domestic product (up from less than 35 percent of GDP before Bush’s spending binge).
There are myriad reasons why government spending of this magnitude hinders economic performance. A large public sector requires an unfriendly tax regime, for instance, and most nations — including the United States — make their tax systems needlessly punitive by imposing high tax rates and subjecting saving and investment to extra layers of taxation. But even if tax revenue floated down from Heaven, excessive government spending would harm growth by misallocating labor and capital. This is largely because of social welfare spending (what budget geeks refer to as “consumption” spending and “transfers”), which diverts resources from the productive sector of the economy. Moreover, many government programs discourage pro-growth behavior (why save when government subsidizes housing, health care, education, and retirement?) and subsidize bad behavior (means-tested programs that make unemployment more attractive than work).
The only good news, at least relatively speaking, is that other nations are in even worse shape. With the exception of Switzerland and a handful of other examples, nations in Europe are burdened by public sectors that consume up to 50 percent of economic output. In places such as Sweden and France, government spending actually consumes more than half of GDP (though Sweden somewhat compensates by having very market-oriented policies in other areas).
Europe’s sclerotic economies should serve as a warning for American policy makers. If government continues to grow, it will be just a matter of time before the United States also is plagued by low growth, higher unemployment, and stagnant living standards. Government spending is not the only policy that matters (see here for additional information), but making America more like France is a big step in the wrong direction.