Voodoo Economics, Part 2

The Unemployment Fiasco

This article is a continuation of our analysis of the Keynesian multiplier and the effects of government spending. Part 1 covers the theory of the Keynesian multiplier, the rationale behind it, and the reasons why it cannot work. In this Part 2, we examine a real-world example where the idea of the Keynesian multiplier has failed to provide the promised results.

In January, 2009, the Obama administration published a brochure with information about the anticipated effect of the American Recovery and Reinvestment Plan (ARRA) on the job market. Read the brochure here or a local copy here.

Unemployment 2007-2009 Of particular importance is Figure 1 on Page 4: predicted unemployment with and without ARRA are compared. Without the recovery plan, predicted unemployment peaks in 2010 at slightly above 9 percent. With the recovery plan, that is, massive government spending and the consequential higher debt, higher taxes, and higher inflation, the Obama administration predicted that unemployment peaks at 8 percent in 2009 and starts recovering.

Only four months later, the predictions are proven wrong by unemployment data published by the Department of Labor, Bureau of Labor Statistics. The image to the right shows the predictions from the brochure (blue) and the true unemployment numbers (red) - click on the image for a large-size version. In the optimistic predictions published by the Obama administration, unemployment would be lower by an average of 0.4 percent per quarter under ARRA than without stimulus spending. The reality shows that unemployment was higher by 0.43 percent per quarter than predicted after massive stimulus spending had taken place. In fact, the current unemployment rate is already higher (9.4 percent in May 2009, 9.8 percent in October 2009) than predicted without stimulus spending (predicted peak of 9.1 percent in early 2010).

Obviously, the predictions were wrong, but why? There are three possible explanations:

  1. The economic crisis is deeper than expected, so much deeper that stimulus spending prevented even worse unemployment rates,
  2. stimulus spending had a negative effect on employment - contrary to the claims of the Obama administration, or
  3. the predictions were intentionally misleading to reduce public resistance against out-of-control spending.
How would ARRA stimulus spending decrease the unemployment rate? Let us consult the brochure. On Page 3, the stimulus spending is detailed:

  1. Substantial investments in infrastructure, education, health, and energy.
  2. Temporary programs to protect the most vulnerable from the deep recession, including increases in food stamps and expansions of unemployment insurance.
  3. State fiscal relief designed to alleviate cuts in healthcare, education, and prevent increases in state and local taxes.
  4. Business investment incentives.
  5. A middle class tax cut along the lines of the Making Work Pay tax cut that the President-Elect proposed during the campaign.

Without doubt, $775 billion is substantial. Let us defer Item 1 above for the moment and focus on the other items on the list. Item 2 are temporary programs to protect the most vulnerable. Employment is a long-term decision, and temporary programs won't change unemplyment trends. While the most vulnerable part of the population will welcome some relief, any money spent for that purpose is not stimulus money. The poorest will buy low-cost articles that are manufactured in China or other low-wage countries, and domestic manufacturers will not benefit. Therefore, they won't employ.

Item 3 is state fiscal relief. Like Item 2, state fiscal relief is not investment, and no long-term effects can be expected. Rather, state budget deficits may be reduced - an incentive to not balance your state budget, by the way - but no link to private business (the sector that employs people and the sector that contributes to the GDP) can be established. Item 5, a middle class tax cut would have a broader effect: the middle class, that is, the majority of the American people, would get more buying power with a middle-class tax cut, and consumption of domestic products could potentially increase with a possible beneficial effect on employment rates in the long run. Unfortunately, we are still waiting for the middle-class tax cuts. Even worse, the Bush tax cuts are still set to expire in 2010, which will further reduce consumption.

Now let's get to Items 1 and 4. Here, the Obama administration finally uses the most important keyword: investment. Unless you count the bailout of the Detroit car companies (and the cementing of uncompetitive labor costs with taxpayer's money), there has been little in terms of business investment incentives. Finally, Item 1 lists government programs. While maintaining a good infrastructure and investing in education is undoubdetly important, government programs tend to be inefficient (the reason is explained in a different article). Spending for areas that are listed in Item 1 will slightly alleviate unemployment, but with the non-investment spending in Items 2, 3, and (hopefully) 5, the budget will be low. Furthermore, government programs do not have an impact on GDP - a fact that we will have to discuss further. Finally, what happens when the stimulus money runs out? A rebound of unemployment because the structural problems were just deferred?

As a consequence of these considerations, we conclude that the possible impact of stimulus spending on unemployment rates is minimal.

This immediately raises the question: why is unemployment rising if stimulus spending has a negligible effect?

To answer this question, we need to analyze the evolution of the current recession. In 2007 and 2008, a speculative housing bubble burst. The housing market was distorted by the community reinvestment act, and private banks were pushed into issuing subprime mortgages. As a consequence, house prices were inflated. At the same time, subprime mortgages were bundled into what is today termed "toxic assets" and sold world-wide. A minor imbalance of the world economic situation (weak economy in Europe and Asia with a weakening economy in the USA) was sufficient to let the housing bubble burst. Overnight, billions of invested money was lost. Banks collapsed. Loans became temporarily more difficult to get. With house prices declining, private consumption dropped. At this time, the crisis only affected the finance sector, and the economy could have recovered from this crisis rather quickly.

Alas, it was now election season. The mass media recognized that candidate Obama was seen by the people as more competent in economics issues. By exaggerating the reduction of consumption into a general economic crisis, voter bias for Obama was amplified, which was perfectly in-line with the mass media who almost unanimously supported Obama. Private consumers became wary by doomsday news and hectic bipartisan activity in Washington, and private consumption dropped further.

We now need to remember that companies - employers - make long-term decisions. An investment, such as building a new plant, must be profitable, or the money won't be invested. Investment is a prerequisite for increased employment. Unfortunately, the private business sector faced two trends. The first was the decline in private consumption. The second was the almost certain victory of Obama and the Democrats. Companies - employers - prepared to face the consequences of a left-wing administration: more bureaucratic obstacles, higher costs (such as cap-and-trade), strengthening of the unions, and likely increasing taxes. To face the new challenges, the companies started shrinking to a new, healthy size: layoffs. Unemployment started to rise. With rising unemployment, private cosumption dropped further, and more layoffs followed.

This vicious circle was met with the bipartisan bailout bumbling in Washington. Huge amounts of money were pumped into unprofitable sectors of the economy. "Stimulus" money was promised: notably, one-time spending. The deficit rose astronomically (see the figure "Deep Impact"). For the private business sector it became clear that higher taxes and higher inflation were inevitable. While a one-time stimulus has short-term effects at best, inflation and taxes are long-term consequences. The companies know that, and in such a deteriorating economic climate, companies are not willing to grow - not willig to employ. Now we have arrived at the red line of the figure above. Unemployment is rising in spite of - and because of - one-time stimulus spending. What do companies need in order to assume the risks associated with growth? A long-term increase in profitability: reduction of government-induced costs, most notably taxes. A permanent tax cut is a powerful growth incentive. Unfortunately, our current administration does not promise long-term tax cuts for businesses. And they can't - somebody has to pay for the federal debt!

Yet, economic advisors of the Obama administration point out that the GDP increases by more than one Dollar for every Dollar spent by the government. This effect is known by the name Keynesian multiplier (see Part 1). In the brochure, the Keynesian multiplier is found, too:

A second step is to simulate the effects of the prototypical package on GDP. We use multipliers that we feel represent a consensus of a broad range of economists and professional forecasters. Our particular multipliers for an increase in government purchases of 1% of GDP and a decrease in taxes of 1% of GDP are given in Appendix 1. They are broadly similar to those implied by the Federal Reserve's FRB/US model and the models of leading private forecasters, such as Macroeconomic Advisers.

Why then hasn't the GDP risen yet? Between January 2000 and January 2008 - this excludes the present recession - GDP increased by 49 percent (ref). This is a 5 percent annual increase. Yet in the first four months of 2009, GDP shrank by 0.4 percent. Statistically, there is no significant increase or decrease of GDP in 2009. If the claim of the Obama administration that the government can "purchase" GDP was true, we should see a steep rise in GDP. The stimulus amount of $775 billion is approximately 5 percent of the current GDP. According to Keynesian economics, the Standard Government Spending Equation is (ref):

Spending Multiplier

where Δy is the increase in GDP, ΔG is the increase in government spending, and bC, bT, and bM are the marginal propensity for spending, income tax rate, and marginal propensity to import, respectively. With small values of bC and bM (small change of spending and import behavior), the denominator is close to unity, and Δy should be close to 5% for the year of 2009 or between 1% and 2% in the first four months, every month. Obviously, this is not the case.

In fact, the theory of the Keynesian multiplier has long since been debunked. Common sense dictates that the notion of the Keynesian multiplier is wrong. Every Dollar the government spends (and thus every Dollar that supposedly buys almost a Dollar of GDP) has been obtained through taxes, that is, taken away from the economy. And now it retuns to the economy twice? A free lunch? Then why have those countries with high tax rates and high government spending (such as Germany and France) consistenly lower per-capita income than the USA? Why should't the government tax all it can (100%), spend like mad and double the GDP every year? There was 100% taxation in the former east-bloc countries. They are dead now, rather than being the richest countries on Earth. If the Keynesian multiplier sounds too good to be true, it probably is.

So what are the conclusions? Let us return to the three possible explanations of the failure of the stimulus to reduce unemployment:

  1. The economic crisis is deeper than expected, so much deeper that stimulus spending prevented even worse unemployment rates,
  2. stimulus spending had a negative effect on employment - contrary to the claims of the Obama administration, or
  3. the predictions were intentionally misleading to reduce public resistance against out-of-control spending.
Clearly, the first explanation is wrong. With GDP almost steady, the economic crisis cannot be deep. In fact, the economy is close to recovery. The second explanation is true as shown by the unemployment statistics. In analyzing the current recession we could see that the anticipated long-term consequences of government spending - deficit, increased taxes, and increased inflation - more than compensate for any short-term benefit; and any short-term benefit would be marginal anyway. The proof is the deviation of the real unemployment from unemployment predicted by the Obama administration.

The third explanation would be hard to prove or disprove. While Keynesian economics are well-known as Voodoo economics ( ref and ref), there are enough people of influence who believe that the Keynesian multiplier is a fact. Maybe the Obama administration fell for it. They should learn hard, and learn soon.

And maybe not. Recently, the Obama administration reported 150,000 jobs "saved or created" and promised 600,000 more jobs "saved or created" by summer through additional spending. In light of the rising unemployment, this is a blatant lie. To quote from the article:

Mr. Obama's comments yesterday are a perfect illustration of just such a claim. In the months since Congress approved the stimulus, our economy has lost nearly 1.6 million jobs and unemployment has hit 9.4%. Invoke the magic words, however, and -- presto! -- you have the president claiming he has "saved or created" 150,000 jobs. It all makes for a much nicer spin, and helps you forget this is the same team that only a few months ago promised us that passing the stimulus would prevent unemployment from rising over 8%.

Maybe the Obama administration knew all along that they were peddling Voodoo economics. They seem impervious to self-reflection. Otherwise, the new spending plans of additional $787 billion cannot be explained. With their massive spending actions, the Obama administration creates an accomplished fact - a runaway government deficit that cannot be corrected even by a future government that really heeds fiscal responsibility. With their massive spending actions, the Obama administration drives us down a one-way road to socialism. Is this bad? Yes: high unemployment and lower GDP makes every American poorer.

What can we expect in the near future?

Monetary expansion is at an unprecedented level. Check out the following figure (ref):

I admit that this figure sends a chill up my spine. When some commodity is in high supply, its value falls. Money is no exception. If there is too much money, its value (that is, its buying power) declines. This is called inflation. The figure aboves gives us an idea just how much inflation we can expect. There is one inevitable consequence: rising interest rates. The brochure that we initially started with assumes (Appendix 1):

We considered multipliers for the case where the federal funds rate remains constant, rather than the usual case where the Federal Reserve raises the funds rate in response to fiscal expansion, on the grounds that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future.

Translated: All daydreaming in this brochure is based on low interest rates.

And the reality? Interest rates have already turned up sharply (ref, ref, and ref). So hurry up if you want to refinance. Your next loan may be unaffordable. Inflation will soon follow, and if you don't get a 10% salary increase, your money will buy you less and less.

These are the fruits of socialism. Everybody gets poorer.

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