Government Spending Cuts And Fallacious Keynesianism

As the so-called "fiscal cliff" approaches, can we count the number of articles foretelling grave economic harm from the impending cuts in government spending?  (Of course, the "fiscal cliff" involves much more of tax increases than spending cuts, but that's for other posts.)

Here's John Crudele in today's New York Post:  "[Either the Republican or Democratic prescription] will result in less spending.  And less spending -- no matter where it's cut from -- will tip an already fragile economy over the edge."

From MediaMatters in September:  "[E]conomic experts agree that cutting spending during weak economic growth damages recoveries and depresses employment."

From the [execreble] Paul Krugman of the New York Times in October:  "Recent spending cuts appear to have done even more harm than most analysts -- including those at the I.M.F. itself -- expected."  (Did you realize that the U.S. government had undertaken "recent spending cuts"?  From what possible set of data can that statement come?)

I could go on, but you get the point.

Those authors speak like they know what they are talking about, but they are completely, totally wrong.

What's the actual evidence in the U.S. economy from massive government spending cuts?  Perhaps you think that the U.S. government has never actually undertaken massive spending cuts within a short period of time.  You would be wrong.  It turns out that the Federal government cut its spending by around 50% or more within a short period twice in the twentieth century, once in 1944-48 and the other time in 1921.  The result both times was a spectacular boom.

Here's a great article from June 2012 by  economist David Henderson about what happened after World War II.  Key quote:

In a 2010 study for the Mercatus Center at George Mason University, I examined the four years from 1944, the peak of World War II spending, to 1948. Over those years, the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP. The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent.

Henderson points out how the disciples of Keynes, most notably Paul Samuelson, predicted disaster would occur when the war ended and were proved spectacularly wrong.  Henderson quotes this prediction of Samuelson from 1943:

[W]ere the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties—then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.

The spending cuts of 1921 tell the same story.  Here is a good article from the Mises Institute in 2009.  Note that, unlike the post World War II cuts,  the 1921 spending cuts did not immediately follow World War I, which had ended in 1918.  But President Woodrow Wilson kept the government spending inflated at wartime levels.  By 1920, the economy was in depression, with 12% unemployment.  In 1921, new President Harding's prescription was to cut government spending in half.

Instead of "fiscal stimulus," Harding cut the government's budget nearly in half between 1920 and 1922. The rest of Harding's approach was equally laissez-faire. Tax rates were slashed for all income groups. The national debt was reduced by one-third.

Result:

By the late summer of 1921, signs of recovery were already visible. The following year, unemployment was back down to 6.7 percent and it was only 2.4 percent by 1923.

And then came the Roaring 20s!

What we have going on is a delusion that I call Fallacious Keynesianism, to be distinguished from real Keynesianism.  I have my disagreements with real Keynesianism too, but Fallacious Keynesianism is completely unsupportable, and, to his credit, Keynes himself recognized that and distinguished his theory from the Fallacious variety.  Nevertheless, essentially all of mainstream media, government, and the liberal commentariat has fallen completely for Fallacious Keynesianism.

The essence of Fallacious Keynesianism is that government spending increases the economy as measured by government GDP statistics, whereas cuts in government spending decrease the economy as measured by those statistics.   Therefore Fallacious Keynesians advocate increasing, or not decreasing, government spending in all circumstances.

To understand the fallacy of Fallacious Keynesianism, you must understand that the government economic statistics, such as the measure of GDP, do not have any good way of measuring the benefit or harm of government spending.  They simply assume that a dollar spent by the government is of equal value to a dollar spent in the private economy, theorizing that if the people choose to make this expenditure through the government they must find it to be of equivalent value to the private alternative.  This assumption is probably reasonable when the government is a small part of the economy.  When the government becomes a large part of the economy and spends vast amounts on wasteful things, the assumption breaks down completely.

Keynes himself in the General Theory considered the obvious example:  suppose the government pays everyone to dig holes and then fill them back in.  Everyone will work hard all the time but will starve.  Meanwhile the government GDP statistics will count the payments to the laborers as of equal value to what they could have produced in a private economy.  If the government cuts spending on the hole digging and filling, its GDP statistics will initially record a decline until the laid off workers find new employment in the private economy. But output of any real value has not declined, and only by cutting the wasteful spending can the resources of the economy be unlocked to produce real wealth in the private economy.

The simple lesson is that excessive and wasteful government spending is harmful, and if government GDP statistics do not initially show a benefit when the spending is cut, that is a defect in those statistics, and does not mean that the economy is not harmed by wasteful spending or benefited by cuts.

I was thinking of trying to explain real Keynesianism, but this post has gotten too long.  Try reading the General Theory.  It is really impenetrable.  My takeaway:  even if there is any real benefit from real Keynesian government spending, it can only work over the shortest term, in trivial amounts, and will always be co-opted into Fallacious Keynesianism by corruptocrats.