Obama’s Big Spending Fallacy Could Ruin the US Economy: A History Lesson

I’m inclined to the view that the Great Depression was a seminal turning point in the history of economic thought. Thanks to that politically-induced tragedy something like 150 years of sound economic reasoning was overturned by two mercantilist fallacies that we now call Keynesianism, the first of which was the demand deficiency fallacy. This clearly leads to the second fallacy that increased government spending can promote growth, especially by encouraging consumer spending.1,2 Both fallacies are responsible for the present economic crisis.

I have been publishing data for years that refutes both fallacies. Unfortunately Keynesianism seems to have taken on the characteristics of a cult that brooks no opposition — including contradictory evidence. Nevertheless, facts are facts and the idea that a high level of consumption as a proportion of GDP is needed to prevent unemployment from rising has been thoroughly refuted by statistical evidence as the following table amply demonstrates.

What’s amusing about this table is that it reveals the so-called laissez-faire Hoover as doubling government spending as a proportion of GDP. (Hoover was well known at the time to being strongly opposed to laissez-faire policies. Thanks to the dishonest efforts of leftwing historians this fact has been turned on its head). This increased spending in dollar terms was far from trivial. Robert P. Murphy points out that for the financial year 2007 the Bush administration would have had to run a deficit of $3.3 trillion to equal Hoover’s “overspending”. (Robert P. Murphy, The Politically Incorrect Guide to the Great Depression and the New Deal, Regnery Publishing Inc., 2009, p. 47).

The data also demolishes the idea that debt is counter-cyclical. From 1930 to 1939 total debt rose by 150 per cent and yet America continued to be cursed by widespread unemployment. (Debt is expected to be 101 per cent of GDP in 2010). So how do we account for the very high level of unemployment? What matters to employers is the cost of labour relative to the value of its marginal product. (Every introductory economics textbook explains this process). It obviously follows that if the cost of labour (the gross wage) exceeds the value of its product persistent unemployment will emerge.

The fourth column in our table contains the productivity adjusted wage. This is arrived at by dividing productivity by the real wage. We can now see that real wages did indeed exceed productivity — and to a considerable degree — with the tragic results that economic theory predicts. No matter which indexes are used the result is always the same: excess wage rates. What makes the third column particularly interesting is that though Canada had no New Deal her employment record during the 1930s was vastly better than the US’s to the extent that on average the US unemployment rate was 3.9 per centage points higher. (Murphy, ibid., p. 104). An important fact that is usually overlooked is that the great bulk of the unemployed were in manufacturing. In 1934 it was calculated

that of a total of almost 14 million persons were without jobs at the peak of unemployment in March, 1933, 6½ million were from the durable goods industries, nearly 6 million were from the “service” industries, and only 1½ million were from the consumption goods industries. Investment activity, in a word, is the tail that wags the industrial dog. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 235).

It was noted at the time and is borne out by the figures in the table that consumption was in fact being maintained and that it was the producer goods industries that were suffering the most, a fact that Joseph Stagg Lawrence, an eminent economist, tried to point out to the public. (The same thing happened during 2000 and 2001 recession). It was patently clear to the more astute economists that consumer spending was not the key to recovery.

Unfortunately for Australia Prime Minister Rudd is as profoundly ignorant of economics and economic history as is President obama. Rudd is arguing that the Premiers’ Plan of 1931 that resulted in public spending cuts deepened the depression and raised the level of unemployment. However, Sinclair Davidson, a Professor in the School of Economics, Finance and Marketing at RMIT, produced a chart showing that unemployment not only peaked in 1931 it then began to fall despite government spending cuts.

Why? He doesn’t say but the following chart provides a clue. Unemployment peaked when productivity reached its lowest point, after which it began to rise as did the demand for labour. But for this to happen the productivity adjusted wage would have to fall. The real wage in manufacturing for full-time labour in 1927-28 equalled 100. In 1930-31 it was still 100. For 1936-37 it was 99. During this period it never fell below 98. (C. B. Schedvin, Australia and the Great Depression, Sydney University Press, 1988, p. 350).

Source: Recovery from the Depression: Australia and the World Economy in the 1930s, Cambridge University Press, edited by R. G. Gregory & N. G. Butlin, 2002,p. 268

Now we have our answer. When productivity fell the productivity adjusted real wage rose which then raised the level of unemployment. Once productivity began to increase again this reduced the productivity adjusted real wage and so increased the demand for labour. Therefore government increased borrowing and government spending had absolutely nothing to do with it. This the lesson of the 1930s and one the classical economists understood. Mill spoke for them when he wrote:

The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained. Taxes are not now esteemed to be ‘like the dews of heaven, which return in prolific showers’. It is no longer supposed that you benefit the producer by taking his money, provided that you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasoning of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided that he expends it all again at the same shop, is a public benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman a fortune. (John Stuart Mill, Essays on Economics and Society, Collected Works of John Stuart Mill, Vol. I, University of Toronto Press 1967, pp. 262-63).

Unfortunately President Obama and his advisors are hell bent on imposing on America unsustainable deficits and spending for which there is no economic justification and whose only result will be a great weakening of the economy. Only an unreasoning and fanatical belief in the power of state can account for such behaviour.

1. The immediate post-war economic situation is highly instructive in that it completely explodes the Keynesian idea that government spending is vital if unemployment is to be prevented from rising. Between 1945 and 1947 the Truman government slashed Federal annual spending from $95 billion to $36 billion — a $59 billion cut in two years, a 62 per cent reduction that amounted to 26 per cent of GDP as it stood in 1945. Instead of the mass unemployment that Paul Samuelson confidently predicted would emerge when the war ended and government spending was slashed America entered an unprecedented period of prosperity.

2. In fact, recovery was already underway before Roosevelt could implement his destructive New Deal policies. Roosevelt was inaugurated on 4 March 1933. I don’t want to be a party pooper but the depression bottomed out “in the late winter of 1932-33” and recovery was clearly underway in the February-March period with the Federal Reserve Index of Production rising from 60 to 100 in July. (Frederick C. Mills Prices in Recession and Recovery, National Bureau of Economic Research, Inc., 1936, p. 307).

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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