Keynes Lives!

I’ve been thinking some more about one of the points made in my earlier post about the policy tools that will be available to combat the next recession. One thing struck me as deserving a bit more investigation: the role of fiscal policy in pulling the US economy out of the last recession. Specifically, can we measure the role that government spending has played in the current recovery? Put another way, can we quantify the good old-fashioned Keynesian effects of federal fiscal policy?

One obvious thing to do might be to look at changes in total employment, and changes in government employment. If the government hired more people, then that would certainly have helped the US economy more generally. But as the following chart shows, the government sector has not added an unusual number of jobs in recent years.

Note: Federal employment data excludes Post Office employees. Government employment for census years (e.g. the year 2000) is taken as the average between the year before and year after the census year.

While the federal government has stopped shrinking in terms of number of employees, neither has it grown much. State and local governments have added workers to their payrolls, but not at an unusually rapid rate. (Note that most of those new S & L workers are teachers; about 800,000 of the S & L employees added between 2000 and 2005 are in education.)

But this is a rather unsatisfactory analysis of the effect of increased government spending on the economy. That’s because a large proportion of government spending – particularly at the federal level – doesn’t put more workers on the government payroll, but instead involves hiring private-sector firms to provide goods and services for the government. For example, increased defense spending has largely gone toward more and larger government contracts to buy defense goods from the private sector. That impact on the economy can not be measured by looking at government employment.

So instead I prefer a different approach. In the following table I have decomposed changes in the total employment in the US into two broad categories: “job losses” due to higher productivity, since productivity growth means that the economy can produce any given amount of output using fewer workers; and “job gains” due to higher demand. The table further breaks down the “job gains” due to higher demand into the major sub-categories of demand: C (spending by consumers), I (spending by businesses), M (imports), exports, and government spending.

Sources: BEA national income data, and BLS employment data.
Note: For simplicity, I (unrealistically) assume that each type of demand growth has the same impact on employment.

Thanks to the rapid productivity growth of the period 2000-05, in 2005 the US economy could have produced everything that was demanded in the year 2000 using about 14 million fewer workers than were actually employed in 2000. However, demand grew over that period, too. So for example, higher consumer and business spending (with imports subtracted from those categories, since we should only count that spending in C and I that went toward domestically-produced goods and services) meant that around 11 million additional workers had to be employed in the US compared to what would have been the case if consumer and business demand had remained at year-2000 levels.

The interesting thing to note is that higher government spending – and in particular higher spending by the federal government – accounted for an unusually large share of the growth in demand over the past 5 years. Higher spending by the federal government meant that roughly two million more people had to be employed to meet that demand than would have been the case if federal spending had remained at the levels of 2000. Note that of the $160 bn increase in annual real federal spending between 2000 and 2005, $130 bn of that was for defense spending.

What does this mean? In a nutshell, this data tells a story of an economy that has been strongly influenced by federal government spending. If it hadn’t been for the defense boom, in particular, it seems possible that the slow employment growth during the period 2000-05 would actually have been close to zero. The tried-and-true Keynesian prescription of having the government spend its way out of recession seems to have worked.

Naturally, this analysis significantly understates the impact of fiscal policy on the economy over the past 5 years because it doesn’t attempt to measure the effects of the tax cuts. It seems safe to suppose that a good portion of the increased consumer and business spending in recent years is the result of lower taxes. Putting that together with this spending analysis would show that fiscal policy had an even larger role in the economic recovery.

The implication for the next recession is sobering, however. Given that the persistent federal budget deficit means that we are unlikely to see another surge in federal government spending, or another round of major tax cuts, fiscal policy probably won’t be able to come to the rescue the next time that there’s a recession. Old-fashioned Keynesianism helped to rescue the US economy from the last recession. But it won’t the next one.

Kash