There were monumental changes in both the economy and economic policies this past year. While business activity continued to decline during the first half of the year, by mid-year the economy began to grow.
Some attribute the turnaround in the economy to an unprecedented 18% increase in federal government spending. However, in spite of much talk about government stimulus, increases in federal spending tend to be associated with economic weakness rather than strength.
Some economists believe that government spending can boost total spending. This view first emerged during the 1930s when total spending collapsed and prices were falling. Few associated the collapse in spending with the Federal Reserve’s monetary restraint. Desperate to restore spending, politicians and economists reasoned that if government increased its spending then total spending would also increase. The problem with this line of reasoning is that the federal government cannot spend money without first taking it from someone else.
Every dollar the government spends represents a dollar it has to either tax or borrow from someone who earned it. Once the government takes it, it can’t be spent by the one who earned it. Hence, neither increases nor decreases in government spending can increase or decrease total spending.
Even though increases in federal spending do not add to total spending, they do tend to weaken the economy. This is because individuals tend to be more careful spending their own money than bureaucrats are in spending other people’s money.
Significant increases in federal spending have been associated with some of the worse economic periods in our history. Among these are the late 1920s and into the 1930s, as well as the late 1970s and early 1980s.
In contrast, periods of strong economic growth have been associated with significant cutbacks in federal spending. From 1921-27 federal spending was cut by 40%, the largest peacetime reduction in history. This period is known as the Roaring Twenties since real growth increasing by almost 50%.
A similar development occurred in the early 1980s. Cutbacks in the growth in federal spending from 1982-87 were associated with twice as much real growth as occurred during the soaring government spending of the previous five years.
The only times that government spending appears to have a positive effect on the economy is when the Federal Reserve is creating more money. This indicates that Fed policy is boosting demand, not government spending.
Until the beginning of 2009 the Fed had inadvertently produced a restrictive policy. The combination of monetary restraint along with rapid increases in federal spending again created serious economic problems.
A shift toward monetary stimulus through most of the past year should produce relatively strong spending this year. However, significant increases in federal spending will continue to create problems for many businesses.
With massive federal government borrowing to support its spending, there are fewer funds available to lend to businesses. Banks also face ongoing pressure from regulators to reduce C&I loans so they can rebuild capital.
Although monetary stimulus should boost spending in 2010, depressed real estate prices and a relative scarcity of credit mean businesses will face additional finance-related challenges in the year ahead.