Fiscal responses to recent recessions have shown Keynesian stimulus to be ineffective.
Fiscal responses to recent recessions have shown Keynesian stimulus to be ineffective.
N ever in American economic history was so much owed by so many for so little. The de facto application by both political parties of Modern Monetary Theory, effectively unlimited borrowing and monetary stimulus, is ultimately disproving Keynesian economic principles, of which MMT is a bastardized reductio ad absurdum.
The effort to stimulate the U.S. economy out of its pandemic and lockdown-induced slump has entailed borrowing to the tune of 25 percent of GDP. After an initial burst reopening economic sectors closed by government fiat, the recovery has proceeded at a historically slow pace. While GDP has recovered to its pre-pandemic level, it remains below even the sluggish trend from the Great Recession recovery, as illustrated in the following chart.
This shortfall has fallen particularly hard on the private sector since government spending absorbed an additional average of 9.3 percent of the economy since the pandemic onset. Unlike GDP, industrial production and non-farm employment remain 2.5 and 2.8 percent below their pre-pandemic highs.
To be sure, the pandemic recession was unprecedented in its nature and severity, but, historically, the U.S. has experienced a number of severe downturns. To compare them with today, the following chart displays the drawdown, or percentage decline from the previous peak, for each of GDP, industrial production, and non-farm employment.
In this chart, each new high registers as zero; there is no “drawdown” from the most recent high. Since economic series such as these grow over time, many of the chart’s figures are at zero. When data declines, the percentage deviation from the most recent high (or zero) registers as the percentage drawdown. Thus, each series is comparable over time based on its performance at the time.
With its associated lockdowns, the pandemic recession registers in the chart as especially severe for employment, but several historical episodes appear comparable for the other series. While these downturns are identified by the National Bureau of Economic Research official recession dating, specific drawdown dates for individual indicators may vary, because the NBER looks at a range of indicators.
An indication of the pace or strength of the downturn and recovery can be developed by comparing its depth with its duration from preceding peak to trough for the downturn and from trough to next peak for recovery. The chart below compares the strength of recoveries for the above cycles and includes the fiscal impact measured by increases in federal debt relative to GDP from the period before the downturn to the debt’s maximum level.
For each indicator, recoveries have lost force over time. Recoveries with little or no federal fiscal response in the 1920s and 1950s surpass both the New Deal and more recent recoveries featuring vigorous federal fiscal action.
The federal fiscal impact can be compared with the strength of downturn declines and their recoveries. The chart below compares downturns’ declines to changes in federal debt.
One might expect the steepest downturns to be associated with the largest increases in federal debt. Income-support programs such as unemployment and food stamps climb during a downturn, and the federal government often responds with counter-cyclical policy to offset the downturn. However, there is no meaningful relationship between the strength of a downturn measured by industrial production or GDP and the resulting federal fiscal impact. There is a significant relationship between employment downturns and federal finances, but that is due solely to the pandemic downturn and the mass layoffs following lockdowns.
Similarly, it might be expected that a strong budgetary response could accelerate recoveries. The chart below compares recovery strength with federal fiscal changes. (The pandemic recovery is projected to continue at its pace of the last 12 months.)
In fact, there is a negative relationship between the recovery’s strength and the federal fiscal impact. For GDP, the relationship is not meaningful, but for industrial production and non-farm employment, it is significant. Keynesian adherents might say the weaker recovery causes the federal borrowing, but, if federal borrowing and spending have any positive economic effect, it should show up at magnitudes of 20-40 percent of GDP, and it does not.
Stanford economist John Taylor found that consumption did not respond to the massive but short-term post-pandemic federal stimulus. One rationale for stepped-up federal borrowing was to drain savings with federal borrowing and convert it into consumption from stimulus payouts, but, as shown in the chart below, private savings have just increased further, matching and financing the federal deficit.
The federal fiscal engine is just spinning its wheels, with no expansionary traction. We can be thankful the federal spending has provided major relief, but, as counter-cyclical policy, it has failed. Despite the GDP recovery, the private sector remains well below its pre-pandemic heights. Of course, some of the private sector’s woes are attributable to imbalances and shortages in the economy. The federal government has splashed out around 25 percent of GDP and is surprised there are imbalances?
Naturally, what causes growth, recession, and recovery needs examining from more perspectives than that of government borrowing alone, but, looking at the last century of American economic history, evidence for the effectiveness of deficit stimulus is weaker than its proponents acknowledge. These debates will persist because of the economy’s complexity, but the year ahead may shed some light. The Congressional Budget Office projects federal spending and deficits to fall by 8 percent of GDP in 2022. The Penn Wharton Budget model projects the combined reconciliation and infrastructure bills to be between 1 and 2 percent of the 2022 economy. Either way, the fall in federal fiscal impact is dramatic and would be expected to depress growth, presenting a Keynesian conundrum. If the economy declines, it would be consistent with Keynesian principles but illustrate their long-term ineffectiveness; the deficit can’t just keep increasing forever to keep an economy growing. If the economy grows strongly despite the steep fiscal drop-off, Keynesian principles may no longer apply to the U.S. economy, if they ever did. The latter scenario may have ironic political implications as well.