1937 or 1930?

Economists continue to debate the lessons of the Great Depression. This is important because, if they get it wrong, our economy will suffer for years. We could easily repeat Japan's "lost decade", which is also being debated.

The two economic theories come down to the role of the government. One side says that government spending is the only thing keeping us from falling over the abyss. The other side says that the government is interfering with the natural economic recovery and making it worse.

The pro-government spending side it championed by Paul Krugman and endorsed by President Obama. They believe in a simplified version of Keynes. There are several core beliefs that the neo-Keynesians have:

1. During economic downturns, the government has to increase spending in order to make up for the decreased private spending.
2. All spending is good. The usual example is to hire one person to dig holes and a second one to fill in the holes.
3. Government spending is more efficient than tax cuts or rebates since taxpayers might save some of the money or use it to pay down debt. Government spending can be targeted to do the most good and none of it will be "wasted".
4. There is a multiplier effect where a portion of each dollar spent is re-spent. President Obama expressed this at the ground-breaking for the 10,000th project when he said that lunch workers would benefit from the money spent by the road workers.
5. We should not worry about short term debt. The time to worry about the debt is after the crisis has passed.
6. The economy was recovering from the Great Depression until 1937 when FDR decided to do something about the growing national debt. The resulting cutbacks caused a new recession.
   

There are problems with many of these points. The biggest one is that it assumes that employers are stupid and will make long-term hiring decisions based on short-term stimulus projects. Take the example that President Obama gave of the lunch worker. If you owned a lunch counter near a construction site and your business increased because of the construction, would you assume that the increase was permanent and expand your facility or would you add temporary workers and assume that business will return to normal when the construction project ends?

Obama's example of the lunch counter worker has an additional problem - it assumes that the construction worker would not eat lunch without the stimulus. In this example, the stimulus moved where the lunch is eaten and may have increased the amount spent. There are better examples but real life intrudes. If the government gives a rebate to a worker, he may spend it or he may bank it. Having the government hire the same worker to dig holes is supposedly more efficient but that same worker may bank his hole-digging wages.

There is some evidence that government spending crowds out private spending rather that stimulating it. The money for this spending has to come from somewhere - either borrowing, new taxes, or high inflation.  Currently businesses are holding huge reserve funds. Collectively they worry that there will either be a double-dip downturn or that the government debt will affect them. Either way, this is affecting their spending.

The idea that government spending is targeted sounds good in principle but the actual stimulus bill that was passed had more to do with politics than efficiency. Spending was not targeted at areas with high unemployment. It was closer to old-fashioned pork-barrel spending except names were removed to make it harder to identify earmarks.

The idea of spend today, save tomorrow sounds good on paper but tomorrow never comes. Government spending increases in the bad times. When the good times come, the pressure to deal with the debt and the size of government is off. No one wants to make hard economic choices when times are good and economists like Krugman insist that it is harmful to cut when times are bad. The result is ever-expanding government and government debt. At some point the debt becomes so burdensome that it strangles the government. Greece is already at that point. Spain is making major cutbacks to avoid the same fate. Krugman thinks that their problems would be solved if they could devalue their currencies but that would raise the future cost of borrowing.

The opponents of the neo-Keynesians point out that the economy was recovering from the crash of 1929 until the government involved itself in 1930. That's when unemployment skyrocketed. There was a similar crash in the 1980s. The government did nothing and the stock market recovered without pulling the economy into a decade-long depression. The fear is that we will repeat the mistakes of the 1930s instead of the lessons learned in the 1980s.

The effects of government stimulus are debatable. Obama's economic advisers made their reputations saying that stimulus spending never worked (once they went to work for Obama then insisted that "This time is different"). There have even been studies that show that cutting government spending can cause an economic boost.

The neo-Keynesians, at heart, believe that the government knows better than the people how things should work. It is no coincidence that a president who took over health care believes that the economy cannot mend itself without government aid.

The impulse to help is deeply ingrained. Back when children grew up on farms they were taught not to help a hatching chick. If you helped it you inevitably injured it but a chick that hatched on its own was healthier. The same applies to an economy but the ivy-league lawyers running the government cannot believe this.