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by Charles W. Kadlec
A bedrock article of faith among all proponents of Federal government spending is that it adds to aggregate demand, and therefore, has a positive effect on the overall growth of employment and the economy "“ hence the widely accepted sobriquet of "stimulus" for virtually all government hand outs and spending.
But now, the failure of the record $787 billion increase in government spending to spur employment growth and a breakthrough study by three Harvard Professors provide a substantive challenge to those that simply assert that government spending is good for the economy.
A little more than a year ago, President Obama signed the American Recovery and Reinvestment Act, claiming it would "save or create up to 3.5 million jobs." In the 15 months since then, non-farm government payrolls have increased by half a million jobs. But those gains have been more than offset by the loss of 1.4 million jobs in the private sector.
That alone should give anyone who sincerely cares about the plight of the unemployed reasonable doubt as to the efficacy of yet more government spending to stimulate that economy. In addition, a new study by three Harvard Business School Professors Professors, Lauren Cohen, Joshua Coval and Christopher Malloy, shows that an increase in Federal government spending is associated with a significant contraction in the private sector. In the face of higher government spending, the average firm reduces employment, cuts capital spending and research and development, and suffers a decline in sales growth (Do Powerful Politicians Cause Corporate Downsizing).
In order to isolate the effect of changes in government spending on the private sector, the authors used the novel approach of identifying an increase in Federal spending at the state level that is associated with the ascension of one of that state's Senators or Congressmen to the chair of one of the top-three committees in the Senate or House, respectively. By comparing the private sector's economic behavior relative to other states and through time, their approach effectively normalized the results for all other general economic and political variables. What distinguished these states from the rest of the country was that Federal earmarks and discretionary state-level Federal transfers increased from the year before and relative to other states due to -- in economists' parlance -- a random or exogenous shock. In other words, their study reveals the "unseen" consequences of an increase in Federal spending.
Here is a summary of the results for the 40 year period ending 2008:
The authors speculate that the increase in government spending crowds out the private sector by doing projects the private sector would have done, by hiring away employees and by creating uncertainty associated with government involvement. Not surprisingly, the private sector's retrenchment was strongest when unemployment is low and capacity utilization high. But, it was also evident during recessions and periods of economic slack.
These research results shed important light on the the actual -- as opposed to the promised -- affect of the rapid increase in Federal spending during the past year. It appears that whatever jobs were created by the unprecedented increase in government spending came largely at the expense of private sector employment. In other words, the claim that unemployment would have been even higher were it not for the stimulus package is highly suspect. The more likely explanation is that the increased spending failed to stimulate the economy because to a very large extent it simply crowded out the private sector.
In an interview published by Harvard Business School, co-author Professor Coval says:
"Our findings suggest that they (public policymakers) should revisit their belief that Federal spending can stimulate private economic development. It is important to note that our research ignores all costs associated with paying for the spending such as higher taxes or increased borrowing. From the perspective of the target state, the funds are essentially free, but clearly at the national level someone has to pay for stimulus spending. And in the absence of a positive private-sector response, it seems even more difficult to justify federal spending than otherwise."
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