More Defense Spending Won’t Save the Economy

By Benjamin Giltner of Cato. 

"The Trump administration has failed so far to deliver on its affordability promises. Yet, in a recent Department of Defense video on X, Secretary Hegseth boasted that the administration’s $1.5 trillion proposed defense budget would “supercharge” the American economy. It’s not exactly a novel plan.

The secretary’s statement echoes a long-standing argument since the publishing of NSC-68 in 1950: More defense spending is good for the economy. Of course, as with all federal spending, defense budgets certainly do affect Americans—just not in the way Secretary Hegseth thinks. 

Instead of boosting economic growth, increased defense spending stunts the US economy, wastes money, and raises costs for Americans.

True enough, defense spending can create jobs and contribute to the economy. But this misses a more fundamental question: Which type of federal spending is most beneficial for the economy? The federal government can spend and borrow only so much money, and there are only so many resources and workers to go around. Should scientists be hired for defense research or domestic manufacturing? Should land be used for missile production or building a school? With limited resources and people, policymakers need to know how to spend federal dollars efficiently to limit waste and bloat. 

Herein lies the central problem with Hegseth’s argument: Of all federal outlays, defense spending creates the least number of jobs. And the reasoning is simple—it is a “parasitic output.” The finished products from defense spending—tanks, missiles, bullets, and so on—leave the market once they are made. When that $4 million Patriot missile is built, that’s it. That $4 million either sits in storage or explodes in combat. Parasitic output is accounted for as part of a country’s gross domestic product, which is why, among other reasons, measuring defense spending as a contribution to GDP is misleading. 

Increased defense spending also weakens America’s manufacturing industry, an economic sector in rough shape these days. The workers, research, and capital that could’ve been used to strengthen domestic manufacturing are being used to make weapons. Yes, building new weapons may increase employment rates. But such an obsessive focus on defense production means missing out on the wider employment and economic benefits of manufacturing other products with higher returns on investment. 

Additionally, increased defense spending puts upward pressure on inflation. As the federal government pumps more money into the economy with little return, inflation rises. To offset this, governments have three primary options: increase interest rates, raise taxes, or reduce spending in other sectors. All three options are politically unpopular. 

Reducing defense spending is the logical position for policymakers to take. Reforming the weapon acquisition process and walking back US military commitments abroad, for instance, are compelling policy options. But bolder action is needed. A spending cap should be placed on the defense budget, which is in fact how these budgets were made prior to the 1960s. Such a cap would force the military to make use of set funds, laying down an imperative to spend efficiently.

Matching the defense budget to America’s national interests makes sense in theory. And indeed, this is what the current Planning, Programming, Budgeting, and Execution process aims to do. Yet, threat inflation regularly goads Congress into paying any price to safeguard against exaggerated threats.

Proponents of hiking the defense budget argue that proposals to reduce defense spending put money before national security and that less spending in a world characterized by risk is radical. But what is truly radical is the notion that the United States can sustain its exorbitant defense spending indefinitely. It’s also radical to suppose that there are no trade-offs with federal spending. And it is radical to separate economic conditions from national security. 

If the Trump administration is serious about lowering costs for American families, it cannot pretend that defense spending is somehow exempt from basic economic realities. A larger Pentagon budget does not create prosperity out of thin air. Lawmakers will need to scrutinize defense spending more heavily if they hope to fix the country’s economic woes."

The Myth of Alan Greenspan as the ‘Maestro’

The longtime Fed Chairman had many successes but he fed the credit mania that led to the 2008 financial panic

WSJ editorial. Excerpts:

"The bad turn came in the 2000s after 9/11 and the dot-com bust. Influenced by then Fed Governor Ben Bernanke, Greenspan became preoccupied with the risk of deflation. In June 2003 Greenspan cut the fed funds rate to 1% and kept it there for a year, though the second Bush tax cut had passed Congress in May and the economy had begun to surge.

Greenspan tightened money slowly after that, despite rising oil and other commodity prices. Thus was born the great credit mania of the mid-2000s. These columns warned consistently in that era that the Fed was too easy for too long, and Greenspan let us know in often contentious phone calls that he didn’t like our then-lonely warnings.

Only in 2005 did Greenspan finally say publicly that housing prices had become “frothy.” But by then the credit mania and housing bubble were already long building."

"Congress pressed Fannie Mae and Freddie Mac to guarantee subprime mortgages and “liar loans.” To his credit, Greenspan in the 2000s was an ally of the George W. Bush White House in pressing Congress to shore up the capital standards of Fannie and Freddie."

"Greenspan never admitted the failure of monetary policy or of the regulators at the time who had allowed Citigroup and other banks to create the off-balance-sheet vehicles that failed." 

Quantitative easing and the Fed’s free lunch problem

By Steve Swedberg of CEI. Excerpt:

"QE operates primarily through asset price channels, which means that it compresses risk premia and increases market responsiveness to central bank communication. This can create artificially elevated asset prices, encourage greater risk-taking during periods of accommodation, and also increase financial system exposure.

Over time, this weakens the informational role of prices. Capital allocation becomes increasingly shaped by policy-driven conditions instead of market-based signals. That shift can reduce the efficiency of investment, thereby directing resources less consistently to their most productive uses.

Because productivity is the primary driver of long-run growth, wages, and economic resilience, even incremental distortions in capital allocation can weigh on the economy’s underlying performance over time. What begins as a stabilization tool can, if sustained, alter the structure of financial decision-making.

Setting the stage for the hard part

Against this backdrop, balance sheet reduction is a means of re-establishing clearer price discovery and restoring policy space for future downturns. It is a step toward rebalancing the role of the Federal Reserve’s balance sheet in monetary policy. QE has altered financial markets in ways that persist well beyond the crisis it was meant to address. Sustained intervention weakens the role of market signals and makes financial conditions more reliant on policy-driven forces. As these effects become embedded in market behavior, stepping back from QE becomes more difficult. The central challenge is whether the balance sheet can be reduced without severe consequences."

We Haven’t Stopped Paying for the New Deal

‘Far from ‘right-sizing’ the government, FDR expanded it into areas it was never supposed to tread,’ writes Robert E. Wright.

Letter to The WSJ.

"Younger generations have learned—despite what their history textbooks have repeated ad nauseam—that government policies caused and exacerbated the Great Depression. The New Deal wasn’t only unnecessary to achieve what David M. Kennedy calls “the conditions of modern society” (Letters, Dec. 10). It hurt many Americans then and continues to do so today.

Far from “right-sizing” the government, FDR expanded it into areas it was never supposed to tread, including retirement annuities, healthcare and higher education, all of which unsurprisingly constitute the most dysfunctional parts of the modern economy. In the process, he also weakened the Bill of Rights, impoverished blacks and stymied women’s return to the workplace.

 

Devaluation of the dollar alone induced the economy to rebound strongly off the March 1933 bottom. All the rest, including the National Recovery Administration, gold confiscation, the Tennessee Valley Authority and endless other top-down tinkerings slowed or reversed the initially robust expansion.

Many other New Deal programs stymied subsequent market development. Most tragically, perhaps, rural electrification held back green-energy technologies, including windmills and batteries, for decades. In many areas, like southern Alabama, the program subsidized the electrification of the summer homes of the wealthy more than it aided farmers. I could go on.

Robert E. Wright

Mount Pleasant, Mich.

Mr. Wright is author, most recently, of “FDR’s Long New Deal.”"

The UK Becomes a Case Study in How Not to Fix a Floundering Economy

Britain’s budget “fixes” reveal how fast a nation can worsen its finances by treating a supply-side problem as a demand-side one.

By John Phelan AIER. 

"In its manifesto for the 2024 general election, Britain’s Labour party listed “Five Missions to Rebuild Britain,” the first being: “Kickstart economic growth.” 

The party’s second budget since winning that election, delivered on November 26 by Chancellor of the Exchequer Rachel Reeves, suggests it has already abandoned that mission — and offers a cautionary tale to other governments on what not to do.

Tax, Borrowing, and Spending Hikes 

Before the election, the Financial Times quoted Reeves admitting that, unlike previous incoming chancellors, she would not be able to claim she had “looked inside the books and realized things were even worse than they looked from the outside, giving a flimsy excuse for immediate tax rises or spending cuts.” She promised no increase in national insurance (NI, a payroll tax like Social Security), income tax, or Value Added Tax (VAT, a national sales tax).

Once elected, Reeves claimed she had, after all, looked inside the books — and discovered a £21.9 billion “black hole” in government finances. This supposedly arose from the previous Conservative government’s failure to spend enough, curious given that in 2023–2024, government spending as a share of GDP was higher than in all but seven of the previous 75 years.

Reeves now had her “excuse for immediate tax rises” in the October 2024 budget. Public sector workers were rewarded for supporting Labour with a £9.4 billion pay hike — 42.9 percent of the alleged “black hole” — while the perpetually cash-hungry National Health Service received £1.5 billion. To fund this, Reeves raised taxes by £40 billion — the largest increase since 1993 — including a two-percentage-point hike in employer NI contributions. She denied breaking her pre-election promise, noting that the employee share was unchanged, but this convinced no one. Overall, taxes were forecast to reach “a historic high” as a share of GDP.

Incredibly, the Office for Budget Responsibility (OBR, Britain’s version of the Congressional Budget Office) projected that Reeves’ budget would push government spending, taxes, borrowing, inflation, and interest rates up, while driving employment, disposable income, and GDP growth down.     

 The Economy Crashes

This is exactly what happened.

The unemployment rate is up from 4.3 percent in the three months to October 2024 to 5.0 percent in the three months to September 2025 and the number of “payrolled employees…fell by 117,000 (0.4 percent) between September 2024 and September 2025,” according to the Office for National Statistics. Over 40 percent of organizations reported reducing employee numbers in response to the payroll tax rise, according to last month’s Bank of England Decision Maker Panel survey, and one-third said likewise for a hike in the minimum wage.  

Growth of Total real pay, 2.4 percent in the three months to October 2024, is down to 0.7 percent in the three months to September 2025. Much of this is due to resurgent inflation. Annual growth in the Consumer Price Index is up from 2.3 percent in October 2024 to 3.6 percent in October 2025. “The government has undoubtedly added to, and extended, the inflation problem with its generous public pay settlements and minimum wage increases,” says Paul Dales, chief UK economist at Capital Economics. 

“The underlying fiscal outlook has also deteriorated since October,” the OBR noted in March, but it has continued deteriorating and, in November, it reported that “Borrowing in 2024-25 is £12 billion higher than estimated at the time of the March forecast.” Meanwhile, Martin Wolf notes for the Financial Times, “the yield on UK government bonds is one of the highest among all advanced economies.” Indeed, British government bond yields are now higher than those which brought Liz Truss down when she was said, by Reeves, to have “crashed our economy” in 2022. Kier Starmer’s government finds itself in the difficult position of having levels of borrowing and the cost of that borrowing increasing at the same time. Of course, it is a situation they chose to put the country in.    

More Taxes, Borrowing, and Spending Hikes 

Before the November 26 budget, Reeves — like some fiscal Hubble telescope — had discovered yet another “black hole.”

Closing it required raising “taxes by amounts rising to £26 billion in 2029–30, through freezing personal tax thresholds and a host of smaller measures,” the OBR noted. Freezing the thresholds will push 5.4 million additional people into the higher- and additional-rate tax bands by 2030, in what the Centre for Policy Studies calls the largest tax rise in at least the last 60 years. It breaks another of Reeves’ pre-election pledges — not to raise income taxes — and “brings the tax take to an all-time high of 38 percent of GDP in 2030–31,” the OBR reports.

But again, this wasn’t really about plugging some “black hole” — which Reeves may have lied about anyway — but about financing yet another expansion of government spending, mostly on welfare. “Budget policies increase spending in every year and by £11 billion in 2029–30,” the OBR reports, “primarily to pay for the summer reversals to welfare cuts and lift the two-child limit in universal credit.” Government spending will be higher as a share of GDP in 2030–31 than in 70 of the last 78 years.

Perhaps this could be justified if it were likely to “kickstart economic growth,” as Labour promised — but it won’t. The OBR revised real GDP growth for 2025 up from 1.0 percent to 1.5 percent but revised it downward for every year afterward owing to Reeves’ fiscal measures. Growth now averages 1.5 percent over the forecast, 0.3 percentage points slower than in March. The National Institute of Economic and Social Research estimates that fiscal policy will shave 0.4 percentage points off growth over the next five years. In October, real GDP shrank for the fourth month in a row. 

Lessons for the United States 

The United States shares Britain’s problems of yawning deficits and spiraling debts but, relatively speaking, it does not share its chronic inability to generate economic growth. Since 2008, GDP per capita has increased by 7.3 percent in real terms in Britain compared to 24.2 percent in the US

This Labour government’s economic record illustrates the folly of trying to close budget gaps — driven in part by a vastly expanding welfare state — through payroll tax hikes and minimum wage increases, soon to be joined by higher income taxes. These measures are strangling economic growth in Britain and would do the same in the United States if attempted here. You cannot expand your welfare state by shrinking your economy.

To the extent Labour is still thinking about growth, it diagnoses the problem as one of insufficient demand — much like the Biden administration did with its misnamed Inflation Reduction Act. It isn’t. Britain’s growth problems are supply-side, and so are the remedies. The issue is not a lack of money to spend but a lack of things to spend it on. Perhaps the most important lesson for the United States and any other country facing this familiar cocktail of problems is simple: it’s the supply side, stupid.

In opposition, Labour and affiliated think tanks made noises suggesting they understood this. In office, Kier Starmer and Rachel Reeves have delivered Labour at its most neanderthal, providing policymakers elsewhere with a cautionary example of what not to do."

A Divided Fed Cuts Rates Again—but Why?

The central bank predicts faster economic growth in 2026 but still eases again

WSJ editorial. Excerpts:

"When the rate cuts began more than a year ago, officials predicted they’d get inflation back to the Fed’s 2% target by 2026. That deadline keeps getting pushed back, and in the Summary of Economic Projections released with Wednesday’s policy decisions, the 2% arrival date is now 2028."

"Mr. Powell says this isn’t quantitative easing to achieve lower interest rates or economic growth. They believe they need to expand their asset holdings to match the level of reserve deposits commercial banks are likely to want to hold. But it’s a reminder that the Fed’s post-2008 “ample reserves” policy framework probably will require the Fed to be a net purchaser of Treasurys forever. Remember when this extraordinary Fed intervention in financial markets was going to be temporary?"

FDR’s Faulty Economics

Americans are as capable of shopping on a Nov. 23 that falls before Thanksgiving as on a Nov. 23 that falls after

Letter to The WSJ. 

"Allen Torrey claims that if Thanksgiving were allowed to fall on the last Thursday of November instead of the now-established fourth Thursday, the result in years with five Thursdays would be to “curtail the Christmas shopping season and harm the national economy” (Letters, Dec. 2).

Not so. Americans are as capable of shopping on a Nov. 23 that falls before Thanksgiving as on a Nov. 23 that falls after. Why? Because the amount of money we spend on Christmas gifts is determined by our incomes, our consumer confidence and the price of goods. The number of calendar days between the two holidays is economically irrelevant.

Even if fewer days caused us to spend less on presents, that foregone money would either go toward other consumer purchases or be kept in savings that fund investments. There’s no reason to suppose that “aggregate demand” is affected by how much Americans spend on Christmas gifts—and, hence, no reason to suppose the economy would be harmed if holiday spending fell.

Veronique de Rugy

Arlington, Va." 

Scott Sumner on The Great Depression.

See The Great Depression: Elevator pitch. Excerpts:

"Between 1929 and early 1933, NGDP in the US fell by roughly 50%. So why didn’t all wages and prices also fall by 50%, leaving output and employment unchanged?" 

"The answer is “sticky wages and prices”, which is the key assumption in business cycle theory." 

"when smaller and more unpredictable changes in the purchasing power of money occur, wages and prices are slow to reflect this reality. The economy moves into “disequilibrium”, with either labor shortages (as in 2022), or huge labor surpluses (as in 1933.) A surplus of labor is called unemployment. When NGDP fell in half during the early 1930s, wages and prices did move somewhat lower, but the adjustment was far too small to prevent a major fall in output and employment."

"You can say that the Great Depression was “caused” by sticky wages and prices, but to me that’s like saying an airplane crash was caused by gravity. Sticky wages and prices are a given, what we need is a monetary policy that stabilizes total nominal spending and income, i.e., a stable path of NGDP. We didn’t have that policy in the early 1930s, and this policy failure resulted in the Great Depression."

"In the early 1930s, there were two media of account, US currency notes and gold. There was a fixed exchange rate between them at $1 = 1/20.67 ounces of gold (which is smaller than a dime)."

In 1929, changes in US nominal variables could be modeled in one of two ways, changes in the value of US currency or changes in the value of gold. I found the gold modeling approach to be more useful, as it was a global gold standard and a global depression, so the best explanation needs to look beyond what was happening in the US. For example, the Canadian currency stock fell sharply during the early 1930s. But it’s not useful to think in terms of Canadian monetary policy causing the Canadian Great Depression. Their dollar was also tied to gold, and Canada was an innocent bystander, dragged into depression by monetary disturbances in bigger countries like the US and France, which boosted the global purchasing power of gold.

The US price level fell by roughly 25% during the early 1930s (depending how you measure it.) That means the two media of account (currency and gold) gained much more purchasing power. One ounce of gold could buy a lot more stuff in 1933 than in 1929, as the purchasing power of money is inversely proportional to the price of goods and services. But wages and prices did not fall anywhere near as much as the 50% decline in NGDP and as a result, real output and employment also fell sharply.

In a sense, the economic slump of 1929-33 was caused by a nominal shock—a sharp increase in the value of currency and gold, which depressed spending and output. To explain what “caused” the Great Depression, therefore, we need to explain what caused this nominal shock. Why did the purchasing power of gold rise so sharply during the early 1930s?

Supply and demand is our workhorse model for explaining changes in the value of any good, service, or asset, and gold is no different. Each year, the global supply of gold (the total stock of existing gold) gets a little bit bigger due to the output from gold mines, combined with the fact that very little gold is lost. Gold supply was not the problem.

If there was no decline in the total stock of gold, then any big increase in its value had to be due to an increase in gold demand. (The same is true of Bitcoin.) I argued that the Great Depression was caused by a big increase in gold demand between 1929 and 1933. But it doesn’t take 500 pages to make that simple point. Therefore, I also analyzed the various factors that led to increased gold demand. 

During the early 1930s, major central banks held huge reserves of gold, indeed they held most of the gold that had been mined since the beginning of human history. This gold was held as “reserves”, backing up paper money. People could take a $20 bill to the US government and redeem it for roughly an ounce of gold. A typical government might hold a 40% gold reserve ratio—$4 million worth of gold backing up each $10 million in currency. But the gold reserve ratio was not constant. So why did global gold demand rise so sharply during the early 1930s? Three reasons:

1. Individuals and banks were hoarding currency due to fear of bank failures, and more gold was needed in reserve to back up this extra currency demand.

2. Central banks also hoarded gold, by increasing their gold reserve ratios. They became “cautious”, which individually might make sense but at the global level was counterproductive.

3. Individuals hoarded gold in fear of currency devaluation, especially after countries such as Britain and German left the gold standard in 1931.

The decision of people, banks, and governments to hoard gold was often prudent at an individual level, but socially destructive. The first year of the Depression is the easiest to explain, as it was almost entirely caused by central bank gold hoarding—a higher gold reserve ratio—especially in the US, France and the UK. In each case the motivation for hoarding was complex and it differed from one country to another. After late 1930, bank failures increased and people began hoarding more currency. After mid-1931, private gold hoarding began increasing due to devaluation fears.

In the early 1930s, there was an almost perfect storm of bad luck and bad decision-making, which is why “Great Depressions” are so rare. When you look at other theories of the Great Depression, they generally imply that huge depressions should happen quite often, but they don’t. Thus the 1987 stock market crash was almost identical in size to the late 1929 stock crash but had no measurable impact on the broader economy. The stock crash didn’t cause the depression.

In late 1937, there was a smaller (but still sizable) secondary depression, partly caused by a renewed bout of gold hoarding. You can think of 1929-33 and 1937-38 as the two parts of the Depression that were caused by adverse nominal shocks. Gold hoarding increased for a variety of complex reasons, and this led to lower NGDP and a lower price level. Because nominal wages are slow to adjust, falling NGDP generally leads to much higher unemployment and lower real output, at least in the short run.

Part 3: Counterproductive wage policies

Both President Hoover and President Roosevelt misdiagnosed the Depression. But Roosevelt’s policies were more successful. That’s because while both had counterproductive labor market policies, Roosevelt had an expansionary monetary (gold) policy.

Although wages were “sticky” (slow to adjust) during pre-WWII depressions, workers eventually would accept wage cuts. After 1929, however, Hoover pressured large corporations to refrain from their usual nominal wage cuts, and thus wages were even stickier than during the previous depression of 1920-21. Hoover probably thought that stable wages would help to maintain aggregate demand (NGDP), but in fact the policy reduced aggregate supply, as companies laid off workers when prices fell below the cost of production.

After taking office in March 1933, Roosevelt gradually devalued the dollar, from 1/20.67 ounces of gold to 1/35 ounces in early 1934. To use the analogy at the beginning of this post, this is like making the measuring stick smaller, in order to make all objects you measure appear larger. Normally, that would be pointless, as nothing changes in real terms. But when wages and prices are sticky, a less valuable dollar leads to more output and employment.

By March 1933, industrial production had fallen to roughly one half of its pre-depression level. Just 4 months later, industrial production had risen by 57%, regaining over half of the ground lost during the previous 4 years. That brief boomlet was mostly due to dollar depreciation. If that had been Roosevelt’s only policy, the Depression likely would have ended within a couple more years. Instead, Roosevelt took other (counterproductive) actions, and the Depression dragged on until 1941.

Like Hoover, Roosevelt believed that higher wages would boost aggregate demand. He was confusing cause and effect. Yes, wages often decline somewhat in a deep slump. But that’s an effect of the depression, not the cause. Rich people often have Rolls Royces. But buying a Rolls Royce makes you poorer.

In mid-July 1933, Roosevelt issued a proclamation that essentially forced employers to raise nominal wages by 20% almost overnight. The explosive economic recovery immediately ground to a halt, and by the time the Supreme Court declared this policy unconstitutional in May 1935, industrial production was actually lower than in July 1933. But the Supreme Court was doing Roosevelt a favor, as industrial production immediately began rising rapidly after the Orwellian named National Industrial Recovery Act was rejected by the Court. (Will our Supreme Court do Trump a similar favor on tariffs?)

In my book, I discussed no less than five different wage shocks imposed by the Roosevelt administration, each of which led to a pause in the recovery."

"What are the policy lessons?

"During and after the Depression, the gold standard was gradually weakened, before being phased out entirely in March 1968. Today, we no longer need to worry about gold hoarding causing a depression. When there is currency hoarding, the central bank can now meet the extra demand by supplying additional fiat currency. And US government no longer uses wage policies in the aggressive fashion employed by Hoover and Roosevelt. Yes, we technically have a $7.25 federal minimum wage, but it’s largely meaningless. In many states, wages are now set by the market.

Monetary policy continues to be more erratic than I would like. It was much too contractionary in 2008-09 and much too expansionary in 2021-22. Even so, it has become more stable than earlier in US history. That’s why we haven’t seen a repeat of the Great Depression."

Here is what Timothy Cogley said in 1999 when he was at the Federal Reserve Bank of San Francisco (1999). He is now at New York University:

"First, stock prices were not obviously overvalued at the end of 1927. Second, starting in 1928 the Fed shifted toward increasingly tight monetary policy, motivated in large part by a concern about speculation in the stock market. Third, tight monetary policy probably did contribute to a fall in share prices in 1929. And fourth, the depth of the contraction in economic activity probably had less to do with the magnitude of the crash and more to do with the fact that the Fed continued a tight money policy after the crash. Hence, rather than illustrating the dangers of standing on the sidelines, the events of 1928-1930 actually provide a case study of the risks associated with a deliberate attempt to puncture a speculative bubble."

See Monetary Policy and the Great Crash of 1929: A Bursting Bubble or Collapsing Fundamentals? 

Powell Flips the Fed’s ‘Framework’

The central bank abandons its 2020 idea that inflation above its target can be useful.

WSJ editorial. Excerpts:

"The Fed at that time adopted what it called “flexible average inflation targeting.” That’s Fed-speak for saying the central bank would tolerate inflation higher than its 2% target for a time to compensate for inflation that was lower than 2% for a period."

"inflation hit 9.1% at its peak in June 2022."

"The Fed said sayonara to this on Friday, returning to plain old “flexible inflation targeting”—with the target being 2% inflation."

"failure of the Fed to acknowledge its role in igniting the pandemic-era inflation that we haven’t fully recovered from."

"One question is why the Fed has an inflation target at all. Congress has given the Fed the duty to maintain stable money, and a 2% target over time means a steady decline in the dollar’s purchasing power."

"Why not a target of zero inflation? The fear at the Fed is that this could sometimes mean the economy falls into deflation. That’s a risk, but based on the historical record it’s a relatively small one."

"The era of quantitative easing, however needed during the panic, was supposed to be temporary. Instead the Fed has maintained its $7 trillion balance sheet and pays interest on reserves to the biggest banks. The Fed would do better to return to its previously more modest place in economic policy." 

Powell Plans U-Turn on an Economic Strategy That Soured

The Fed unveiled a strategy five years ago for worries that the economy outgrew. Now, it will formally reset.

By Nick Timiraos of The WSJ. Excerpts:

"The 2020 changes involved two main shifts. First, the Fed said it would allow inflation to run modestly above its 2% target for periods to make up for times when it had fallen short. Second, officials said they would focus only on the unemployment rate being too high, rather than also worrying about the rate being too low, removing some urgency to pre-emptively raise rates and prevent the economy from running too hot."

"But when inflation took off in 2021, the Fed’s commitments to maintain low rates to spur a faster labor-market recovery put officials in a bind. Economic conditions could have reasonably called for rate increases later that year, but the central bank didn’t begin raising rates until March 2022.

By that point, inflation had reached levels not seen in four decades. The “raging inferno,” as one Fed official put it that year, was nothing like the modest overshoot of the inflation target the central bank had in mind.

The delay has sparked a debate among economists about what went wrong. In a detailed study last year, economists Christina Romer and David Romer at the University of California, Berkeley, argued that the 2020 framework itself was a reason the Fed acted so slowly. They concluded that officials became too focused on getting unemployment as low as possible.

“Arguably, this asymmetry contributed to a delayed response to the inflation surge of 2021-22,” said Donald Kohn, a former Fed vice chair, at a conference last year." 

Others "fault significant forecast errors made by the Fed and many outside economists in 2021—that inflation would prove so short-lived that the Fed shouldn’t adjust rates in response."

"The Fed misjudged how the U.S. economy’s capacity to produce goods and services had declined, and as a result “it kept in place an exceptionally accommodative monetary policy longer than it would have,” said Richard Clarida, who was Fed vice chair in 2020, in a lecture." 

‘False Dawn’ Review: The Mirage of Recovery

America’s leaders in the 1930s subjected the country to a series of bizarre economic experiments. Most of them backfired.

By Judge Glock. He reviewed the book False Dawn: The New Deal and the Promise of Recovery, 1933–1947 by George Selgin. Excerpts:

"Franklin Delano Roosevelt . . . and his advisers had no clear explanation for the collapse and his subsequent New Deal would amount to a series of experiments."

"with a few exceptions, FDR’s experiments did not work."

"by 1939 the unemployment rate was still 17%."

"the Roosevelt administration mistakenly worried that there was too much money in the economy."

"In the early part of the New Deal the amount of money the Fed pumped into the economy shrank."

"deficits as a percent of the economy were hardly different during Roosevelt’s time in office than they had been at the end of Herbert Hoover’s. While the New Deal spent more, it also imposed new taxes on food and payrolls. The result was a bigger federal government, but not one that relied on deficits as stimulus."

"The earliest solution they hit on . . . was to restrict production and thus raise prices. The National Industrial Recovery Act that passed in mid-1933 turned much of the American economy over to giant cartels. Industries colluded to raise prices and unions colluded to raise wages. The result was fewer goods on the market and an immediate economic collapse that would still be remembered today if it hadn’t been surrounded by so many others."

"It paid some farmers to plow their cotton back underground and others to kill their breeding sows before they could produce too much pork. Later economic studies confirm what common sense would suggest: Destroying crops and livestock isn’t an ideal route to prosperity."

"he administration’s tight-money preoccupation led the Treasury Department in 1936 to start buying up the incoming gold just to bury in its vaults. That, together with a series of union strikes inspired by New Deal labor policies, produced the “Roosevelt Recession,” which reversed most of the modest gains the nation had made since FDR assumed office."

"John Maynard Keynes noted in 1934 that the administration’s wild swings in policy kept investors on edge. “The important but intangible state of mind, which we call business confidence,” Keynes wrote, “is signally lacking.”" 

The Government Spending Multiplier: A Survey of Empirical Literature

What do empirical studies tell us about the effect of government spending on economic output?

By Jack Salmon of Mercatus. Excerpts:

"This literature review examines the wide-ranging estimates of the fiscal multiplier—the effect of government spending on economic output. Despite extensive empirical exploration, estimates of the fiscal multiplier span from –3.00 to 3.00 and are influenced by model assumptions, theoretical innovations, state-dependent factors, and dataset choices. This review discusses methodological advancements, including state-dependent estimates, and explores how the multiplier varies under economic slack, at the zero lower bound (ZLB), and with large public debt burdens. The review finds that multipliers are generally within the range of 0.50 to 0.90, with higher estimates during economic slack and at the ZLB and lower estimates for regimes with high public-debt ratios. The degree of state dependence is more modest than suggested by earlier research. Robust evidence that ZLB multipliers are larger than 1.00 is scarce. The paper concludes by calling for more dynamic models and cross-country comparisons to lead to a better understanding of the nuanced effects of fiscal stimulus." 

"In the aggregate, government spending multipliers broadly fall within the range 0.50 to 0.90, in line with the range of estimates offered by Ramey (2019) and consistent with recent meta-analyses of large datasets.4 Some studies find higher multipliers (close to or above 1.00) during periods of economic slack, but the evidence is mixed, with many results suggesting only modest differences compared with expansions. At the ZLB, where monetary policy is constrained, multipliers are often found to be slightly higher, but robust findings indicate that they remain below or near unity. High public debt generally reduces fiscal multipliers, with some studies showing negative long-term effects as debt levels rise significantly. Although some theoretical models predict higher fiscal multipliers for government investment spending compared with consumption, robust empirical data often show minimal differences, with investment multipliers frequently constrained by significant crowding out of private investment. Overall, the degree of state dependence is more modest than suggested by earlier research. The literature also underscores the importance of recognizing distinct phases of multiplier effects—impact, peak, and long term. Although short-term impacts may boost output, long-term effects often diminish or turn negative due to reduced private investment and consumption, emphasizing the role of anticipatory effects and private-sector responses."

Taking Government Out of GDP, An Update

By Peter C. Earle & Thomas Savidge. They are both Research Fellows at the American Institute for Economic Research. Excerpts:

"While the BEA publishes a measurement titled “Value Added by Private Industries (VAPI),” it does not get nearly as much attention as it deserves. The most recent data show that VAPI contributes to just under 89 percent of all economic growth. Despite this, GDP is still the more prominent metric, in part because the BEA treats government spending as a value added to the economy." 

"VAPI includes private outputs that are purchased by government (i.e. a defense contractor) while GDPP (Gross Domestic Private Product) treats those purchases as part of “Government Consumption and Gross Investment.”"

"A cursory glance at the BEA’s description of government assumes that all levels of government “contribute to the nation’s economy when they provide services to the public and when they invest in capital. They also provide social benefits, such as Social Security and Medicare, to households.”

The description also notes that the government gets its revenue taxes, transfers, and fines, as well as rent and royalties. It fails to mention, however, that government receipts come at a cost. That cost, what economists call opportunity cost, is the next-highest valued use of that money.

We can see this effect reflected in the BEA’s own data. When examining the growth of government and the private sector both before and after 2000 in our analysis published last year, government growth (both federal as well as state and local) outpaced that of the private sector. Below is an updated analysis of last year’s findings. Note that the same still holds true: Government outpaces the growth of the private sector, especially state and local governments.

 

Source: United States Bureau of Economic Analysis, Department of Commerce. Table 1.1.6 Real Gross Domestic Product, Chained Dollars, Authors’ Calculations. 

 

Source: United States Bureau of Economic Analysis, Department of Commerce. Table 1.1.6 Real Gross Domestic Product, Chained Dollars, Authors’ Calculations. 

Furthermore, we find that the private sector has grown 33 percent slower per year since the start of the new millennium. It is also important to remember that transfer payments, such as Social Security or unemployment insurance, are excluded from GDP estimates of government spending because those transfers are counted toward private spending. 

Furthermore, we find that the private sector has grown 33 percent slower per year since the start of the new millennium. It is also important to remember that transfer payments, such as Social Security or unemployment insurance, are excluded from GDP estimates of government spending because those transfers are counted toward private spending.

 

Source: United States Bureau of Economic Analysis, Department of Commerce. Table 1.1.6 Real Gross Domestic Product, Chained Dollars, Authors’ Calculations. 

A recent review of the academic literature on government stimulus in the economy finds that government stimulus makes, at best, modest, short-term contributions to economic activity.  In the long-term, however, the review finds that government stimulus effects “often diminish or turn negative due to reduced private investment and consumption, emphasizing the role of anticipatory effects and private-sector responses.”

Economists, both past and present, have argued that calculating government contributions to the economy is more complicated than official GDP calculations claim. Economist Patrick Newman notes Nobel Prize-Winning Economist Simon Kuznets’s own objections that government was treated as “an ultimate consumer” on par with private consumers regardless of whether private citizens valued government consumption and investment. Newman takes Kuznets’s concerns further and argues that such positive treatment of government in economic growth calculations opened the door to the flawed views of Modern Monetary Theory.

Alternatively, economists Vincent Geloso and Chandler S. Reilly examine government consumption and investment minus defense spending, called “Defense-Adjusted National Accounts”. The result is a much lower level of GDP, but the clear lesson “that wars do not improve living standards.” These challenges to the status quo of economic growth calculations help, in the words of Geloso and Reilly, “bridge the gap between official economic data and the perceptions of the American public.”"