The Keynesian Growth Discount

Editorial do WSJ

For three long years, the U.S. has been undertaking an experiment in economic policy. Could record levels of government spending, waves of new regulation and political credit allocation, and unprecedented monetary stimulus re-ignite growth? The results have been rolling in, and they represent what increasingly looks like an historic mistake that deserves to be called the Keynesian growth discount.

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The latest evidence is yesterday's disappointing report of 1.8% in first quarter GDP. At this stage of recovery after a deep recession, the economy is typically growing by 4% or more as consumer confidence returns and businesses accelerate investment as their profits revive. Yet in this recovery consumers are still cautious and business investment remains weak.

Some of the first quarter's growth slump is due to seasonal factors such as bad weather and weaker defense spending. In the silver lining department, the private economy grew faster than the overall GDP figure because government spending declined. But even maintaining the 2.9% growth rate of 2010 would mark an historic underachievement for a recovery after a recession that was as deep as the one from late 2007 to mid-2009.

The most recent recession of comparable depth and job loss was in 1981-1982, when unemployment hit 10.8%. Huge chunks of industrial America shut down and never re-opened. Yet once the recovery began in earnest in the first quarter of 1983, the economy boomed. As the nearby table shows, growth exceeded 7.1% for five consecutive quarters, and it kept growing at nearly a 4% pace for another two years. Growth didn't dip below 2% in any quarter until the second three months of 1986. This was the Reagan boom.

Now look at the first seven quarters of the current recovery. Only briefly has growth hit 5%, in the fourth quarter of 2009 as businesses rebuilt inventories that had been pared to the bone. Growth has been mediocre ever since, sputtering to a near-stall in the middle of last year, accelerating modestly late last year, and now slowing again. This recovery is as weak as the much-maligned "jobless recovery" of the last decade, which followed a mild recession and at least gained speed after the tax cut of 2003.

Most striking is that this weak growth follows everything that the Keynesian playbook said politicians should throw at the economy. First came $168 billion in one-time tax rebates in February 2008 under George W. Bush, then $814 billion more in spending spread over 2009-2010, cash for clunkers, the $8,000 home buyer tax credit, Hamp to prevent home foreclosures, the Detroit auto bailouts, billions for green jobs, a payroll tax cut for 2011, and of course near-zero interest rates for 28 months buttressed by quantitative easing I and II. We're probably forgetting something.

Imagine if President Obama had introduced his original stimulus in February 2009 with the vow that, 26 months later, GDP would be growing by 1.8% and the jobless rate would be 8.8%. Does anyone think it would have passed?

Liberal economists will blame this latest slowdown on spending cuts across all levels of government, and government spending did fall in the first quarter. But those modest declines follow the biggest government spending binge since World War II that was supposed to kick start the economy and then stop. Remember former White House chief economist Larry Summers's mantra that stimulus spending should be timely, targeted and temporary?

With deficits this year estimated to hit $1.65 trillion, are we really supposed to believe that more deficit spending will produce faster growth? Would $2 trillion do the trick, or how about $3 trillion? Two years after the stimulus debate began, the critics who said all of this spending would provide at most a temporary lift to GDP while saddling the economy with record deficits have been proven right.

The good news is that the private economy seems to have enough momentum to avoid a recession in the near term, but the danger is that growth will continue to be subpar. The evidence is that the combination of spendthrift fiscal policy and a wave of new regulatory costs and mandates are restraining business expansion and hiring.

Then there's the threat of higher tax rates on investment and business that we dodged for two years after the GOP won Congress but that President Obama has now promised for 2013 if he is re-elected. This too deters the animal spirits necessary for robust growth. The great risk is stagflation, a la the 1970s, when easy money tried to compensate for bad fiscal and regulatory policy, which led to sluggish growth, rising prices and declines in real wages.

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The contrast in results between the current recovery and the Reagan years is instructive because the policy mix was so different. In the 1980s, the policy goals were to cut tax rates, reduce regulatory costs and uncertainty, let the private economy allocate capital free of political direction, and focus monetary policy on price stability rather than on reducing unemployment. This is the policy mix we need to rediscover if we are going to escape our current malaise and stop suffering from the Keynesian discount.