Pete Souza/White House

Vice President Joe Biden watches President Barack Obama sign into law the American Recovery and Reinvestment Act of 2009.

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  • Gov't can directly increase GDP, or indirectly reduce it - which has more effect on the #economy ?

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  • Higher spending on employment only creates #jobs in the #government not the #privatesector

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  • The #economy could return to normal if we deny the government's continuing calls for more #stimulus

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This article appears in the February 20, 2012 issue of National Review.

Although our economic situation has been glacially improving, the recovery has been much slower than the Keynesians in the Obama administration promised. According to their calculations, the massive stimulus was supposed to produce a miraculous free lunch, with every dollar of government spending generating an additional 50 cents of GDP growth in the private sector.

While devout Keynesians such as Paul Krugman have argued that the slow recovery is due to the insufficient size of Obama's plan, a new study by the National Bureau of Economic Research provides the strongest evidence yet that the Obama stimulus was doomed to failure.

"A new study by the National Bureau of Economic Research provides the strongest evidence yet that the Obama stimulus was doomed to failure." - Kevin A. HassettIn the study, economist Valerie Ramey of the University of California, San Diego, has explored the links between government spending and private activity. Her goal was to estimate the output multiplier — that is, the factor by which government spending increases total economic activity — by precisely assessing both the direct and the indirect effects of stimulus.

Government can increase GDP directly by driving up demand but at the same time reduce it indirectly-either by discouraging consumption and investment, as privatesector participants hunker down in anticipation of future tax hikes to finance the stimulus, or because an increase in government spending can divert workers and capital from the productive private sector. The question Ramey seeks to answer is which effect predominates, the positive or the negative.

The nearby chart summarizes Ramey's results, which use data from 1939 to 2008 and a sophisticated statistical method that allows her to control for a number of other factors. The red line is a composite that depicts the course of a typical spending shock (i.e., an increase in government expenditures). It has been normalized to peak at 1 percent of GDP. As the line indicates, spending shocks typically take a while to work through the system (in part because some projects are not really shovel-ready), peaking around the fourth quarter after the adoption of higher spending.

The green line, another composite summarizing Ramey's results, shows the effect of this stimulus on private spending. It does not depict all changes in private spending, just the changes that are attributable to the stimulus. It mirrors the red line-decreasing immediately, finding a trough around the fourth quarter, and dissipating by the 14th quarter. When government goes up, the rest of us go down.

Click to view a larger version of the chart.

Ramey finds that the reduction in private activity does not completely offset the positive immediate effects of higher government spending, but the total impact is far lower than stimulus advocates assumed. On balance, an extra dollar of government spending increases total GDP by only about 50 cents, because of the private spending it destroys. In other words, the multiplier is .50, where 1.00 would mean the stimulus had no effect on private spending; 1.50 was the Keynesians' rosy free-lunch prediction.

Ramey also studied the impact of higher spending on employment, finding that Keynesian stimulus does tend to create government jobs, but does not create any private sector jobs. She summarizes: "I thus conclude that on balance government spending does not appear to stimulate private activity."

Interestingly, according to the Bureau of Economic Analysis, the U.S. economy grew at an annualized rate of 2.8 percent in the last quarter of 2011, an improvement over the 1.8 percent increase in the third quarter. Private spending rose in the fourth quarter through increases in personal consumption, exports, and private inventory investment, while government spending fell by 7.3 percent.

This is exactly the pattern we would expect if our recent history were driven by the forces evident in the chart. Applying Ramey's results, we should now be in that glorious moment when government spending falls, private spending increases, and the economy returns to normal. That pattern will continue if we have the sense to ignore calls for more stimulus.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.

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