Spending Our Way to Stagnation

This article appeared in the National Post on February 1, 2010.
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Many governments have responded to the economic downturn by increasing the size of the public sector. It was remarkable how quickly they resuscitated the theory that assumes more government spending can boost economic growth.

Popularized by John Maynard Keynes in the 1930s, the theory is based on the notion that government can “prime the pump” by spending money, which then begins to circulate through the economy. Keynesian theory sounds good but it overlooks the fact that, in the real world, government can’t inject money into the economy without first taking money out of the economy.

Any money that the government puts in the economy’s right pocket must be borrowed, which means the money comes out of the economy’s left pocket. Keynesianism doesn’t boost national income, it merely redistributes it.

The Obama Administration claimed that spending more money would keep the unemployment rate below 8% in the United States, yet it climbed to 10%. The United Kingdom and Canada also suffered continued stagnation after adopting so‐​called stimulus packages. Ironically, statist nations such as France and Germany that resisted the siren song of Keynesianism better weathered the global economic storm.

The recent trend toward bigger government is particularly worrisome because most nations have oversized public sectors. Government spending in industrialized nations now consumes, on average, nearly 45% of GDP with Canada and the United States slightly below average. Australia, Switzerland, South Korea, and Slovakia are the only nations where the public sector claims less than 40% of economic output.

To put these numbers in context, government spending in the industrialized world consumed about 30% of economic output in the mid‐​1960s, less than 20% of GDP between the First and Second World Wars and only about 10% of GDP during the golden century between the end of the Napoleonic wars and the First World War.

While many factors influence economic performance, the negative impact of government spending is one reason why small‐​government jurisdictions such as Hong Kong (where the burden of the public sector is below 20% of GDP) have higher growth rates than nations that have medium‐​sized government, such as Canada and the United States. The same principle explains in part why big‐​government countries such as France often suffer from economic stagnation.

Interestingly, a large body of academic work attempts to measure the growth‐​optimizing level of government. This research is based on the notion there is not much prosperity in a state of anarchy. Governments solve this problem by imposing the rule of law (courts, police protection, etc). Those governmental functions cost money, but they yield big benefits. Moreover, government spending on “public goods” such as basic infrastructure also can facilitate the functioning of a market economy.

That’s the good news. The bad news is that most government spending today is devoted to programs for what is known as transfer spending and consumption spending. These outlays dampen economic growth, according to the research, largely because they displace private sector activity and also require punitive tax rates. Most studies using current economic data show that economic performance is maximized when the public sector is less than 20% of GDP. And if historical data is used, the evidence suggests that government should be even smaller.

Ironically, John Maynard Keynes might not be a Keynesian if he was alive today. He certainly would not be a proponent of big government. In correspondence with another British economist, he agreed with the premise of “25% [of GDP] as the maximum tolerable proportion of taxation.”

Canada and the United States are already far above that level and the burden of government in both nations will climb above 50% of GDP in the future in the absence of real reform. Unfortunately, there is no way to have a European‐​size welfare state without also enduring European‐​style economic stagnation.