Another nail in Keynes' coffin...

The great thing about math is that numbers don’t lie. Even if assumptions are overly optimistic or pessimistic, the resulting equation will remain mathematically true. This is the case when analyzing deficit spending and the validity of Keynesian economics, which we’ve discussed previously is on its death bed. Simply put, the math doesn't add up.

There is an interesting analysis that was just released which debunks the claim that "in a recession, government spending (read: deficit spending) is necessary to stave off a deep recession."

Let's start with the conclusion:

The federal government cannot create prosperity by spending funds that it does not have. It can, however, spend us into poverty by taking dollar balances from highly productive individuals and their business entities, through borrowing or taxing. This process of transferring these assets from income and wealth generators to other government applications has profound economic consequences.

The proponents of Keyneisan economics (and deficit spending) must hold these two important factors to be true: 1) the expenditure multiplier (which we discuss here) is greater than 1.00; and 2) increased government spending will not crowd out private business (and growth). If either point #1 or #2 are untrue, the rationale for deficit spending, at least within the confines of a capitalist system, would be intellectually dishonest and merely partisan (see our commentary on Romer later).

Point #1 begins with the notion that massive deficit spending increases the overall economic pie. That is, for every $1 of deficit spending, GDP increases by more than $1. In the last 10 years the deficit as a percentage of GDP has increased from 18.4% to 24.7%. Howevr, during that same time period,

"[t]he percent of the population working today is 58.6% while prior to the large budget deficit spending of the last ten years it was 64.6%. Our GDP was growing at 4.8% ten years ago, and today we are staggering out of recession."

The same holds true for Japan.

"Its government debt soared from 52% of GDP in 1989 to 184% today...GDP in that country is no higher than it was 18 years ago; its employment is no higher than it was 19 years ago, and there is no inflation since consumer prices are at 1993 levels."

How is this possible? It's quite simple really. Government expenditures must come from taxing or borrowing. Period. In both cases, as the analysis points out, resources are shifted from one sector of the economy to another which doesn't expand the economic pie, but merely its composition. There are historical examples where the government expenditure multiplier was 0 (that is, for every $1 of government spending, private spending decreases by a $1) and there are also examples of the multiplier being greater than 0 but less than 1. As the report illustrates,

"during the extraordinary conditions of World War II and the Korean War the multiplier has been calculated as 0.6, meaning that a $1 rise in government spending would lift the economy as a whole by 60 cents while reducing private spending by 40 cents." 

In an additional study, the conclusion was the multiplier was 1.1. Eliminating the 0 reading, the average is 0.85. Remember that number.

Point #2 simplistically holds that access to capital (in the fungible and economic sense) and the incentive to acquire / spend such capital remains unchanged in the face of increased deficit spending. However, as mentioned above, governments must tax or borrow in order to spend (which, in the event of massive borrowing will require additional taxes). The key is this:

Beginning January 1, 2011 the sizeable tax reductions enacted in 2001 and 2002 will expire. The administration projects that household taxes will rise by a cumulative $1.1 trillion over the ensuing ten year period, while business taxes will rise by $400 billion. This calculation was prior to any taxes enacted in the healthcare bill, and does not account for other taxes such as the recently mentioned value added tax suggested by administration policy advisors.

Like government spending, there is a tax multiplier, which seeks to answer the same question as the government multiplier, but in reverse. That is "an increase (decrease) in taxes will reduce (increase) GDP by how much?"

Dr. Barro estimates that the tax multiplier is minus 1.1, meaning that a $1 increase in taxes will reduce GDP by $1.10. However, Christina Romer, Chair of the Council of Economic Advisors and her husband David in an exhaustive study published in March 2007 found the tax multiplier to be –3.

If the tax multiplier is applied to the estimated increase in taxes, the drag on economic activity will be "between $1.65 trillion and $4.5 trillion."

So, if the government multiplier (the "revenue" portion of our equation) is 0.85 and the tax multiplier is roughly -2.1 (which is the "expense" portion of our equation) "then mathematically this country cannot spend its way to prosperity." That's because in an extremely overleveraged economy,

"monetary policy doesn’t work. Potential borrowers do not have the balance sheet capacity to take on more debt...Currently, borrowers are loaded with excess houses, office buildings, retail space, and plant capacity. No need exists to get even deeper in debt. Moreover, due to rising foreclosures and delinquencies, bank capital has been badly eroded and banks are not in a position to put more risk onto their balance sheets by lending to already over committed borrowers."