Government Stimulus Doesn’t Stimulate

The US government is spending money and running up debt at an unfathomable rate. The US national debt increased by a staggaring $814 billion in just two months. When confronted with this reality, most people just shrug. Policymakers certainly don’t care. They continue to ramp up spending and call for even more. Paul Krugman recently tweeted that we need more government stimulus — ie spending — to stoke tepid demand.

Democrats have never cared about spending and Republicans swear tax cuts will grow the economy and fix the debt problem. But as we’ve reported many times, debt retards economic growth.

Now we have even more evidence that government stimulus doesn’t stimulate. In fact, it has the exact opposite effect, as we can see from Europe’s spending binge.

Economist Daniel Lacalle broke down the numbers in a recent article published by the Mises Institute. As he explained:

We have empirical evidence showing that massive government spending plans and tax hikes generate the opposite effect: weaker economic growth, higher debt and larger imbalances. The probability of attacking potential growth, worsening public accounts and breaching optimistic estimates is more than high.”

Analyzing empirical data over the last 15 years reveals that even if the so-called “fiscal multiplier” of government spending is positive, it’s very poor (below 1). And in most countries, it’s negative. This is especially true in nations that already have high levels of government debt.

In other words, government stimulus is actually slowing down economic growth.

According to Lasalle, “More government spending will not spur growth in economies where the public sector already absorbs more than 40% of the GDP, and where the previous large stimulus plans have generated more debt and stagnation.”

Government spending in the US is currently estimated to be around 35.8% of GDP.

Lasalle said adding tax hikes to the equation is even more damaging.

The IMF analyzes 170 cases of fiscal consolidation in 15 advanced economies from 1980 to 2010 and finds a negative impact of a 1% increase in taxes of 1.3% in growth two years later. Additionally, the vast majority of empirical studies going until 1983 and especially in the last fifteen years, show a negative impact of tax increases on economic growth and a neutral or negative impact of increases in spending on growth. Moreover, studies on the effect of bigger tax hikes on tax revenues reveal a negative impact on receipts. In fact, a 1% increase in the marginal tax rate may reduce the taxable income base by up to 3.6%.”

Lasalle says that the main reason for the economic stagnation in the eurozone is the massive fiscal stimulus implemented over the last two decades.

The US isn’t far behind the curve when it comes to spending and fiscal stimulus. In fact, spending is the driving force behind the surging deficits. The mainstream tends to focus on the Trump tax cuts as the culprit. But in fact, Uncle Sam saw a healthy increase in revenue of about 4% in fiscal 2019. Meanwhile, spending was up 8 percent last year, coming in at $4.45 trillion. There were significant increases in outlays for both domestic and military spending.

In other words, the US economy is already getting massive amounts of fiscal stimulus and the economy isn’t even in a recession.

Lasalle sums up the situation in the EU. It should be read as a warning for the US.

The problem of the eurozone is not lack of government spending or taxes, but the excess in both. The string of spending increases announced daily in Europe disguise an extremely dangerous bet: that the ECB will bail out the eurozone forever, especially because the diminishing effects of monetary and fiscal policy are evident. Tax cuts will not work either if those are not matched with efficiency improvements and red tape cuts precisely to ensure that public services continue to exist within thirty years. Burdening the private sector with more taxes and increasing an already bloated government spending may lead the eurozone to the Argentine paradox. By ignoring the sources of wealth generation as well as job creation and expelling them with confiscatory and extractive policies all that is achieved is unemployment and stagnation. The eurozone cannot expect to achieve the growth it has not delivered repeating the same mistakes, further weakening an economy that needs to bet on attracting investment, reinforcing growth and improving technology and the competitiveness of companies. When politicians charge an economy with large and growing fixed costs, without prioritizing investment attractiveness, productivity and economic freedom, they jeopardize the welfare they pretend to defend. The problem of productivity, growth, and employment is not solved by putting obstacles to investment and increasing extractive measures. Growth and the welfare state are not strengthened by putting up political spending and debt as pillars of an economy.