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Election 2008: Obamanomics and Its Achilles' Heel

by: Money Morning June 19, 2008    

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Presidential hopeful, Barack Obama, recently told The Wall Street Journal that he intended to lift the United States out of recession through a burst of government spending on infrastructure and a venture capital fund for the new energy sector.

Obama has made few economic mistakes in his campaign - he avoided the economically counterproductive proposal to cut petrol taxes between Memorial Day and Labor Day backed by both John McCain and Hillary Clinton - but he has shown his Achilles’ heel with this proposal. There may be many reasons to increase government spending, to better defend America or to introduce a more generous healthcare plan or other social programs, but helping the economy recover is not one of them.

In the long run, higher government spending makes the economy worse.

This may seem heretical to those brought up on the doctrines of John Maynard Keynes. Or maybe it’s just simply reactionary - a position to be expected from a Reaganite mossback who fails to recognize that the world has changed. 

But the Keynesian doctrine that public spending can boost an economy out of recession fails to distinguish between two effects of a public spending surge: a larger budget deficit and a transfer of resources from the private to the public sector.

A larger budget deficit does indeed boost the economy in the short term, as expenditure increases, regardless of whether that deficit is attained through tax cuts (such as this year’s “stimulus”) or higher spending. However, it also increases public debt, thus incurring greater costs for future years, and in times of tight liquidity (which we have not seen since the early 1990s) it can force up interest rates, “crowding out” financing in the private sector.

Obama has not recommended a larger budget deficit; indeed it is difficult to believe that he could. The annual deficit is already approaching $500 billion, and the revenue effects of the 2008 slowdown have not yet been felt, since corporate taxes and individual taxes on large bonuses are both paid in arrears - it will thus be early in 2009, about the time of Obama’s inauguration, if he makes it, that the true effect of the slowdown is seen in a deficit that will almost certainly yawn beyond $500 billion.

Obama may save money by withdrawal from Iraq (though that withdrawal might well take a considerable time) but he also plans to spend money though his health plan; there will thus be no money to spare.

The problem arises with higher public spending, the transfer of resources from the private sector to the public sector, however it is financed.

By definition, private sector spending is economically optimal; it reflects the owner of the resources’ view as to the best use of those resources. Public spending, on the other hand, cannot be economically optimal except by accident, because it represents bureaucrats, however well meaning, making choices on behalf of others, which are unlikely to coincide with the preferences of the beneficiaries.

On the investment side, public sector investment frequently results in losses because of the lack of market signals showing the investor where to put his or her (or rather the taxpayer’s) money. Finally, in a political system like the United States, where lobbying is powerful, resources that flow through the public sector are themselves subjected to a tax of unnecessary boondoggles and pork-barrel spending, further inflating public-sector costs compared to the private sector.

This is not just theory. Statistical studies using Organization for Economic Cooperation and Development [OECD] public spending and growth rate data have shown that both the level of public spending (in terms of gross domestic product [GDP]) and its rate of increase are inversely correlated with economic growth, with the combination of the two factors explaining slightly over half the differences in growth rates between different countries and different time periods.

This is intuitively sensible; a large public sector starves the productive private sector of resources, stifling productivity growth, while a rapidly growing public sector sucks up all the new resources generated by economic growth, further starving private enterprise.

There are numerous examples of public sector growth stifling economic growth. Back before modern statistics, the sharp rise in public spending under thirty-first President Herbert Hoover (which was extraordinarily matched with a huge tax increase in 1932) was a major contributor to the depth of the Great Depression.

Meanwhile Britain kept public spending under control, cutting public sector wages by 10% in 1931 when times for all were hard, and had both a shallower Great Depression and a much shorter one; output was above its 1929 level by 1934 and grew rapidly from then on, well before serious rearmament began.

Well into the era of modern statistics, France and West Germany both enjoyed “economic miracles” in the 1950s and 1960s, then growth dropped sharply - in the early 1970s for Germany and the late 1970s for France.

When you examine the statistics you find out why.

The leftist Social Democrat Chancellor Willy Brandt increased German public spending by 10% of GDP in 1970-75. West Germany then enjoyed slow growth in the 1980s before it entered stagnation through a further increase in public spending by 7% of GDP in 1990-96 (related to the reunification with East Germany).

In France, the conservative Georges Pompidou died in April 1974, and his successor Valery Giscard d’Estaing, followed in 1981 by the leftist Francois Mitterrand, ratcheted up public spending by no less than 14% of GDP between 1973 and 1984.

Then there’s Japan. The “Lost Decade” of the 1990s would have been grim anyway, because of the collapse of the 1980s stock market bubble, but the Japanese government certainly didn’t help by pushing public spending up by 8% of GDP between 1990 and 2002. Only after Junichiro Koizumi reined back public spending in 2003 did growth resume. Like Obama, Japanese leaders believed that infrastructure spending would boost the economy; they raised it to 6.5% of GDP, then the highest in the world - and saw the policy miserably fail.

There’s a lot to like about Barack Obama, and a fair amount for investors to like about his policies. But a look at global history shows his belief that public spending in and of itself would boost the economy is contrary to reality.

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This article has 14 comments:

  •  
    Jun 19 09:16 AM
    Thanks for the reasoned commentary. Helping to keep Seeking Alpha part of the rational and civil web community - whether one agrees or not with the views put forward.
    Reply
  •  
    Jun 19 09:35 AM
    "By definition, private sector spending is economically optimal; it reflects the owner of the resources’ view as to the best use of those resources."

    You are indeed a Reaganite mossback!
    Reply
  •  
    Jun 19 10:09 AM
    This country is literally falling apart.

    We need to stop sending money to "help the world" and start using that money as an infrastructure investment in the USA.

    Hopefully you'll never be driving across a bridge that collapses beneath you like those poor people in Minnesota.

    But if it does, I'll bet (as you're falling 50 feet to your death) that you will have wished the USA had made an "infrastructure spending to boost the economy failure attempt" on that bridge.

    Is this your rational? Building bridges won't boost the economy, so let's not take any action until they collapse from old age.

    Building airports won't boost the economy, so let's wait until we have at least one plane crash per day before we start solving the problem.

    It's time to put the USA first and the rest of world second. We can't afford to be the worlds mother and it's time we start taking care of ourselves first.
    Reply
  •  
    Jun 19 11:36 AM
    Ron Paul had it right. Close all overseas military bases ASAP. Stop being the world's policeman and take care of our own.
    Reply
  •  
    Jun 19 12:15 PM
    "Or maybe it’s just simply reactionary - a position to be expected from a Reaganite mossback who fails to recognize that the world has changed."

    Considering that Reagan and Bush I and now Bush II were responsible for the largest budget deficits in U.S. history, it is ridiculous for a "Reaganite mossback" to be lecturing Obama about budget deficits.

    "Public spending, on the other hand, cannot be economically optimal except by accident, because it represents bureaucrats, however well meaning, making choices on behalf of others, which are unlikely to coincide with the preferences of the beneficiaries."

    This is mostly superficial nonsense. Public spending ultimately reflects the social choices made by a democratic process and is the amalgamation of each and every voter's preferences and not some faceless bureaucratic process.

    "But a look at global history shows his belief that public spending in and of itself would boost the economy is contrary to reality."

    Are you suggesting that the growth experienced during Reagan was illusory? Seems to me that you are carefully cherry picking your history.
    Reply
  •  
    Jun 19 01:04 PM
    skjellifetti, it seems to me it's you who are "cherry-picking&q... of the Reagan policies... it wasn't Reagan's defense spending that spurred the growth. If anything, that hindered the full effect of his tax policies and reduction in regulation, which were the true driver...
    Reply
  •  
    Jun 19 02:27 PM
    What Reagan did 25 years ago doesn't mean our country can keep doing it. Time has changed, and government policies must reflect that.

    Reagan did the sensible thing by cutting taxes and stimulate private consumptions back then. In 2008, when our infrastructure is crumbling, when our energy security is in the gutter, when home owners own less than 50% of their homes, and when consumer debts are at all time high, it should be obvious that a different STRATEGY for the country is needed.
    Reply
  •  
    Jun 19 02:51 PM
    jswede - It wasn't my article. I'm just providing some easily observable counterexamples to show how badly argued this article is. And since we cannot rerun the Reagan experiment exactly with only a change to the defense spending (the "change one thing while keeping all else constant" that is the basis of scientific experimentation), we will never know if your statement that defense hindered the full effects of the Reagan tax cuts is true or not.
    Reply
  •  
    Jun 19 09:04 PM
    There hasn't been a conservative in the whitehouse in a long long time. If you think Bush is a conservative, you really need to go look up what conservative means.

    "Aimless" public spending can be a problem. If the spending is occurring in areas where growth can occur naturally after a kick start (such as R&D), then there are benefits.

    However, dumping billions into the military to expand US bases and to fight wars that were a mistake to begin with is downright crippling. It's siphoning off money to foreign countries, while at the same time burying us in debt.

    When you actually develop a PLAN to spur the economy with public projects, then benefit can arise from it. Unfortunately, it seems most public spending is handled in an ad-hoc manner, with little oversight or direction.

    You can't judge based on percentage of GDP. Like all financial analysis, you have to see HOW the funds were spent. Think Apollo Space Program vs. Alaska Bridge To Nowhere. We got a lot of technological advancements from one, and would have gotten jack from the other.

    ~X~
    Reply
  •  
    Jun 20 10:46 AM
    An increase in public spending funded by debt may cause higher interest rates which reduce IRR and private projects are canceled or deferred. Obama proposes to extract the money for his public projects from taxpayers who otherwise would dump it into hedge funds (or loan it to the government). Certainly, Some hedge funds speculate with their investors funds. But others support IPO's and enforce efficiency on LBO's they take private. The economy is a complicated structure with many feed back loops that only become obvious after the fact. The generalizations of the author are too simplistic to be of much use.
    Reply
  •  
    Jun 20 11:43 AM
    Obama will tax you all so the country can spend more. Doesn't make cents to me? He is ignorant on any form of economics. It is no wonder his wife is finally proud of America.
    Reply
  •  
    Jun 20 03:28 PM
    I would like to see more spending on public infrastructure but not if it is for the wrong reasons. It is presumed that "investments"... in roads always generates a cornucopia of benefits. This mantra has been chanted so often at Chamber of Commerce Meetings that it is unassailable with any statistic or dose of reality. In the past fifteen years, the government has been collecting and generating data to prove the negative impact on the economy of delays. This is a corollary to the idea that roads always produce benefits.

    The problem, as I see, it is that there is no way that will discriminate between consumptive and productive infrastructure "investments.&quo... The will to bow to an objective system of project selection is just not there. Since at least the 60's there have been in place mechanisms that assign value to human life and the cost of accidents and property damage in order to discriminate between a bad project and a worse project but the input has been cynically manipulated by invented, intangible or external benefits that makes any action look good. The value of human life has gone up about 6 times the rate of inflation in the last 40 years and once you do the carbon foot print analysis and the asthma death calculation, it seems like every project has a moral imperative.

    According to the General Accounting Office, a government program should have a benefit equal to 125% of the cost. That has been on the books since the Clinton Administration. The only thing that it has deterred is the Federal Highway Administration from launching a program to help state highway departments build roads for the purpose of generating economic development.

    Accountants or engineers with accounting skills have been marginalized in most highway departments least they protest silly infrastructure expenditures that are earmarked by congress. Other infrastructure work such as levees and dams are quite controversial and not likely to be built except after a disaster proves their worth. Water infrastructure is also in a state of neglect. The glitzy solution of desalinization has proven more expensive than the lab models actually predicted. Traditional methods of supplying water are no longer thought to be environmentally friendly. Train and Light Rail investments are pushed even though they account for less than 1 percent of all passenger miles traveled. Even in New York, most passenger miles are consummed by bus. Some seats on these trains cost $60,000 each and their survival depends upon the gasoline taxes produced by the private automobile. The length of pipeline transport infrastructure is actually shrinking every year since the sixties by About 0.4 percent per year of pipeline length is lost every year. Some gas lines have been ordered to lower pressure because of their age and corrosion. Airport congestion can only be improved with new runways. The entire Interstate needs to be upgraded to a six lane minimum east of the Mississippi.
    The phenomenon of toll roads proves that there is value it road infrastructure but it is not easily exploited. People will pay to go where they want to go but they do not want to pay so someone else can go somewhere in a bus, train or personal auto in a donee state. Accountants can easily prove a toll road is a good and sustainable investment by applying strict rules that have served the capital markets well for years. They do this however by ignoring external, theoretical and questionable benefits and just focus on the fundamentals of the Internal Rate of Return.
    Reply
  •  
    Jun 20 05:32 PM
    The article is both well reasoned and a worthy contribution to civil discourse on the issues involved. It is the following comment by Skjellifetti that I find hopelessly naive:

    "Public spending ultimately reflects the social choices made by a democratic process and is the amalgamation of each and every voter's preferences and not some faceless bureaucratic process."

    The unfortunate civic reality is that voters are typically given a choice between alternative seekers of power who will feel much more obligation to reward the moneyed, personally known interests who bought them power than to honor campaign promises made to the faceless masses.

    Until his recent speech condemning irresponsible black fathers (an obvious effort to capture the votes of Bill Cosby fans among a white majority), the only thing I've found to admire about Obama is his brilliant success in selling an image and a hope totally at odds with the sordid reality of his wheeling and dealing in advancing his career and economic interests (interests that he and his wife hypocritically urge others to eschew in seeking "the common good").
    Reply
  •  
    Jun 23 01:37 PM
    Alphameister,

    You sound like the modern Bush Republican who really doesn't believe in Democracy when the policy outcome isn't what you think it should be. It seems you further pretend to like rational discourse in one breath while mouthing unsubstantiated smears against those with whom you disagree in a second breath. You are exactly the type that the rest of us are so revolted by after 8 years of ideologically driven politics that has utterly failed to solve a single damn problem and created many, many more of its own. There is a reasonable chance that Obama will be elected in a landslide. Better learn to deal with it.
    Reply
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