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At the recently concluded G-20 summit of the world's leading economies, the U.S. found itself at odds with other nations over the path of government spending. The U.S. believes high spending is still necessary to prevent a renewed recession, but other nations believe spending must fall to reign in unsustainable deficits and debt.
Who's right?
The U.S. position relies on the textbook Keynesian model of business cycles, which suggests that government spending can reduce or shorten recessions. According to the model, recessions occur due to a lack of demand for the economy's good and services. Government can remedy this shortfall by increasing its own demand, say by building highways, purchasing military aircraft, or funding research. Or, government can increase demand from consumers and firms by cutting taxes or increasing transfer payments like unemployment insurance, Medicaid, or Social Security.
Although the Keynesian model is widely taught and utilized, it remains controversial as a justification for government spending.
The crucial problem is that, according to the model, any kind of spending can increase demand and help the economy recover from a recession. So if the government pays people to dig ditches and fill them up, the Keynesian model says this spending is beneficial.
Few people take this aspect of the model seriously, however; instead, advocates of Keynesian spending assume that government has plenty of "good" projects available, such as extending unemployment benefits, building more roads, funding research on green energy, or transferring money to states so they can avoid teacher layoffs.
The claim that Keynesian spending can focus on good projects, however, is problematic. Government spending to moderate recessions needs fast turnaround, yet identifying good projects, planning them appropriately, and implementing them effectively takes time. So spending can easily kick in after a recession has passed.
The timing problem is not disastrous if all spending is for good projects, but that raises the second difficulty. While some government spending on roads, research, or education makes sense, more is not always better since the benefits of extra spending eventually hit "diminishing returns." Considerable evidence suggests that many aspects of government in modern economies have gone well beyond the appropriate balance.
These concerns about Keynesian spending are especially worrying because empirical support for the Keynesian model is far from compelling. The model implies that the impact of increased spending should be greater than the impact of tax cuts, but the existing evidence suggests more like the opposite. Indeed, some empirical evidence finds minimal impacts of spending, while most research finds a robust impact of tax cuts.
Thus the case for Keynesian spending is awkward, at best. If the debt outlook in the U.S. and other rich nations were only mildly negative, then perhaps advocates of spending could still make a case. But the debt outlook is truly bleak; most countries need to cut expenditure enormously.
Some advocates of spending accept the need for cuts but suggest these can wait until the recession ends. The problem with this view is that when better times arrive, tax revenues will grow somewhat, deficits will shrink a bit, and politicians will declare "victory" and ramp up spending still more. Only a crisis can generate true spending reductions, which means the rich nations - including the U.S. - should slash spending now.
