Recipe for Economic Stagnation

This article will very briefly review Keynes and Friedman's basic economic theories as well as empirical economic data and use this information to explain why the government's actions during the current recession will only act to intensify the downturn and prolong recovery efforts.

Milton Friedman demonstrated that Keynesian economic policy lead to stagflation (the combination of low growth and high inflation). Friedman formulated an alternative macroeconomic policy to Keynesianism called Monetarism, which argues that the government cannot micromanage the economy because business owners, investors and consumers will realize what the government is doing and shift their behavior -- this reaction is known as rational expectations.

Monetarism (or rational expectations) in a simplified sense is like the law of gravity -- what goes up, must come down; likewise, what money the government spends today must be paid for by higher taxes tomorrow.

In a major study, highlighted by Alan Reynolds of the Cato Institute, Alberto Alesina of Harvard found that the best way to make an economy grow is to cut government spending while the best way to usher a decline is to increase government spending and taxation. Alesina et al. studied econometric data for 18 large OECD member countries to assess the effects of government spending and taxation on investment.

Figure 1. Change in Private Consumption and Investment versus Change in Government Spending due to The American Recovery and Reinvestment Act as projected using the Smets-Wouters model employed by Cogan et al.

The authors reached three important conclusions:

1. Increased government spending reduces profits while decreased government spending increases profits;

2. Increased taxation reduces profits while decreased taxation increases profits; and

3. Economic growth is implemented by spending cuts while economic decline is implemented by increased taxation - most importantly, these trends hold even for large fiscal expansions and contractions.

During the depression, 15 new government agencies were created, government spending increased by 220%, taxes increased by 68%, and the deficit increased to 24 billion dollars.

Friedman postulated that the tremendous government intervention only perpetuated the depression -- a view that has been validated over time. He stated that,

"far from the depression being a failure of the free-enterprise system, it was a tragic failure of the government."

To paraphrase Mr. Einstein - to repeat the same mistake over and over again is stupid - so stupid that you might start to think it's being done intentionally...

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