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Evidence that increased government spending does not help economic growth [ClearOnMoney]
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Evidence that increased government spending does not help economic growth

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Commentary

Evidence that increased government spending does not help economic growth

There seems to be a clear negative correlation, across OECD nations, between recent increases in government spending and corresponding changes in the GDP growth rate.

It is always amazing to see what can be accomplished in public debates by simply sweeping unspoken assumptions under the rug. Today there are endless arguments between economists, between politicians, and between voters, on how much the government should “stimulate” the economy. In most of the arguments, both sides assume that stimulus works, i.e. that more federal spending does indeed help economic growth; the arguments are about whether it is more important to stimulate, or whether it is more important to balance the budget.

Although economists who favor stimulus do occasionally trot out arguments about how stimulus should, indeed, help growth, I have never seen any empirical data to support the thesis. (This, indeed, is the fatal flaw of economics as a science, that most practitioners have too much faith in models, and spend too little time testing to see if the models have any relation to reality.)

On Sunday Arthur Laffer had an opinion piece in the Wall Street Journal, in which he argues that more government spending hinders rather than helps economic growth (thanks to Barry Hillman for pointing to the article). Much of the piece presents fine-sounding theoretical arguments about why this should be the case. And those arguments might be right. But what makes the article really interesting is that he presents some empirical data.

[stimulus] worked miserably, as indicated by the table nearby, which shows increases in government spending from 2007 to 2009 and subsequent changes in GDP growth rates. Of the 34 Organization for Economic Cooperation and Development nations, those with the largest spending spurts from 2007 to 2009 saw the least growth in GDP rates before and after the stimulus.

The four nations—Estonia, Ireland, the Slovak Republic and Finland—with the biggest stimulus programs had the steepest declines in growth. The United States was no different, with greater spending (up 7.3%) followed by far lower growth rates (down 8.4%). …

In many countries, an economic downturn, no matter how it's caused or the degree of change in the rate of growth, will trigger increases in public spending and therefore the appearance of a negative relationship between stimulus spending and economic growth. That is why the table focuses on changes in the rate of GDP growth, which helps isolate the effects of additional spending.

The data as presented are not in any order that helps understand the argument. Here are the data with nations ordered according to increase in spending:

Nation     Spending_increase  Growth_change

Estonia        12.8            -35.5
Ireland        11.7            -20.5
Finland         8.7            -17.8
SlovakRepublic  7.5            -18.0
Iceland         7.4            -16.2
US              7.3             -8.4
Denmark         7.1            -11.6
Spain           6.9            -10.4
UK              6.9            -11.5
Luxembourg      6.8            -16.2
Japan           6.7            -10.5
Greece          6.3            -11.0
Norway          6.2             -6.7
Slovenia        6.1            -17.1
Netherlands     5.7             -9.0
Portugal        5.6             -6.7
Belgium         5.5             -7.5
Chile           5.2             -8.9
Mexico          5.2            -13.5
Canada          4.9             -7.1
Germany         4.6            -11.6
Turkey          4.4            -15.7
Austria         4.3             -9.8
Italy           4.3            -10.5
France          4.1             -7.7
CzechRepublic   3.9            -14.4
Sweden          3.8            -13.6
NewZealand      3.4             -6.0
Australia       3.3             -3.5
Poland          2.3             -6.3
Korea           1.1             -7.7
Hungary         0.7             -9.9
Switzerland    -0.2             -7.1
Israel         -0.9             -6.2

And here are the data presented as a scatter plot, to test visually for correlation:

The results are quite striking. There seems to be, as Laffer says, a quite significant negative correlation. That is, a higher increase in government spending results in a worse change in GDP growth.

It would be nice if Laffer would write a serious paper, with data sources given in detail, other time periods considered, and significance rigorously tested. But even the above data provide a strong enough argument that it demands a serious answer from the Keynesians. Krugman, DeLong and others have jumped in with knee-jerk criticisms and playground-level personal attacks, but I have not been able to find anyone who addresses the empirical negative correlation.

Data note

The exact headings on Laffer's original table are “Change in government spending as a % of GDP from 2007 to 2009” and “Change in real GDP growth from 2006-07 to 2008-09”. The data source is given as “IMF”, without further detail.

Note that although the argument of Laffer's piece is against stimulus, the empirical data ignores any government intent, as it should, and just looks for correlation between change in spending, which occurs for whatever reason, and change in growth rate. This is a point missed by most of those who immediately criticized Laffer's article.