Federal Spending and Employment

Over the last few months much ink has been spilled over the effectiveness of federal government spending in stimulating job growth and employment. I propose to spill more ink. No sentient resident of Washington State can deny the influence of federal spending on job creation. The development of hydropower on the Columbia River, naval bases (Bangor, Whidbey Island) and ports (Bremerton, Everett) and the role of defense contracts in the growth of Boeing all attest to the regional employment effects of federal government spending. Government spending creates jobs.

But regional job creation is not the same thing as national growth in employment. It is possible that more economic activity here leads to less activity elsewhere, so the net effect is zero, possible but not likely under our current economy. It is even possible that the government expenditures totally displace private expenditures in the affected region.

  If the economy is operating at full employment, increased federal government spending financed by borrowing or taxes just transfers spending and resources from one use to another, and there is no overall increase in employment or output. This phenomenon is known as “crowding out”. Evidence of crowding out through government borrowing would be a rise in real interest rates. Ten year rates are now less than 2% (virtually zero in real, inflation adjusted terms). There is no indication that private borrowers are being discouraged by higher interest rates. However, if there is excess capacity and unemployed resources, increased government spending financed by borrowing (deficit spending) utilizes these resources and increases total output. Current data indicates the economy is operating at less than its potential.

Let’s return to the notion of “crowding out”. This is another way of illustrating the concept of opportunity costs or the foregone uses of resources when they are reallocated to a specific use. At the macro level this cost is only apparent when resources are alread fully employed and a new expenditure pattern develops.

At full employment, increased government expenditure would require a transfer of resources from one set off private uses to another set of uses. This could be accomplished by raising taxes, thereby reducing private consumption and investment and freeing resources from current uses. Increased government expenditures would just result in a transfer of real resources with no increase in real output.

Now let’s assume the expenditure is financed by borrowing from the public (domestic or foreign).Once again, the previous level of domestic investment was consistent with full employment and nothing real has changed other than the composition of output. Under full-employment conditions nothing real changes with changes in government expenditures and revenues. The GDP is unchanged. All effects are compositional, more scientists and fewer pole dancers.

If the economy is operating at less than full employment there are unused reserves of labor and other resources available. Increased government expenditures can lead to increased real output as government expenditures mop up unused or underutilized resources.

 Under this condition it makes no sense to raise taxes to finance the increased activity because increased taxes will reduce expenditures and total expenditures are already insufficient to generate full employment. The efficient option is to borrow the funds from savers. The private loans to the government will come out of excess reserves of the banking system and not crowd out private lending. Therefore increased public spending will increase total spending and employment QED.


There is one potential fly in this expansionary ointment. Economists of The Rational Expectations School argue that the government can’t expand output regardless of the level of employment or the means of financing. They adhere to a version of something called Ricardo Equivalence (Let it be stated that Ricardo did not hold to a strict interpretation of this concept. Like most true believers, the modern supporters of the view have gone well beyond the master’s views.). According to the equivalence principle the current generation recognizes the future tax burdens associated with deficit spending and adjust their current level of saving upward so as to meet the future tax burden. Therefore the drop in current consumption expenditures offsets the increase in government expenditures and there is no stimulative effect to increased government expenditures.

  Obviously raising taxes to pay for government expenditures is offset by decreased private expenditures. You can’t win! Fortunately for fiscal policy, the empirical evidence for this effect is wanting. During the 1981 to 1984 period when deficits increased dramatically there was not a compensating savings offset. So the deficits were expansionary and helped speed the recovery from a severe recession. Reagan’s results were Keynesian in principle.(Herbert Stein noted this at the time with the proper sense of irony). When the Federal Budget went from surplus to deficit under Bush there was no corresponding uptick in saving. In fact the savings rate fell.

As an aside, Alan Greenspan estimated, at the time, that about 20% of the Reagan tax cuts would be recouped through revenue gains. He was too pessimistic. Later estimates placed the figure closer to 30%. Thus a $100 billion tax cut would only increase the deficit by $70 billion. So much for the supply-side arguments, they should rest in peace.

“A regulatory climate that does not appreciate that the financial developments over an extended period of good times will tend to breed the financial environ- ment that leads to the likelihood of crisis and hard times, will not serve this economy well.
                               ” Hyman Minsky (1975)

Federal Spending and Employment

Over the last few months much ink has been spilled over the effectiveness of federal government spending in stimulating job growth and employment. I propose to spill more ink. No sentient resident of Washington State can deny the influence of federal spending on job creation.

The development of hydropower on the Columbia River, naval bases (Bangor, Whidbey Island) and ports (Bremerton, Everett) and the role of defense contracts in the growth of Boeing all attest to the regional employment effects of federal government spending. Government spending creates jobs.

But regional job creation is not the same thing as national growth in employment. It is possible that more economic activity here leads to less activity elsewhere, so the net effect is zero. Possible but not likely under our current economy.

If the economy is operating at full employment, increased federal government spending financed by borrowing or taxes just transfers spending and resources from one use to another and there is no overall increase in employment or output. However, if there is excess capacity and unemployed resources, increased government spending financed by borrowing (deficit spending) utilizes these resources and increases total output. Current data indicates the economy is operating at less than its potent