According to the modern Friedman-Keynes synthesis, there are two tools in the hands of most national authorities that permit them to attempt fine-tuning the economy. The first tool, monetary policy, is the bailiwick of the central bank, which in the United States is known as the Federal Reserve. It has great influence over interest rates, which represent the price of money. Increasing the interest rate is supposed to force the economy to contract, while lowering it is believed to encourage the economy to grow.
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.
– John Maynard Keynes, "The General Theory of Employment, Interest, and Money"
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While Keynes may not have known of any examples of this case limiting the effectiveness of monetary policy, we know of at least two: post-1990 Japan and the post-2008 United States. The failure of monetary policy has brought the importance of the second tool to the fore, which is the fiscal policy wielded by the political authorities. With fiscal policy, increasing taxes and reducing spending is supposed to reduce economic growth, while reducing taxes and increasing spending is believed to increase it. Today's Keynesians and Neo-Keynesians believe that fiscal policy is capable of succeeding where monetary policy failed due to the events of the Great Depression, when Herbert Hoover, FDR and the Democratic Congress jointly embarked upon a gargantuan spending spree that caused total government spending to grow from 11.29 percent of the economy as measured in GDP to 52.97 percent in only 17 years. Most of that growth came as a result of World War II, as 44 percent of it occurred in 1943 alone.
In February, I pointed out that Obama's initial $775 billion stimulus plan was actually 17 percent smaller in relative terms than Hoover's 1931 economic rescue program. Since then, however, the economy has continued to worsen, and the White House has significantly upped the ante with its 2010 budget. The administration now proposes to spend $3.998 trillion in what it estimates will be an economy of $14.2 trillion, which in combination with state and local spending will bring total government spending to 45.29 percent of GDP if its relatively optimistic estimates are correct for 2009. However, if the economy under performs expectations, as it has for the last three quarters, a year-long contraction continuing at the rate of Q1's -6.1 percent growth would increase the G/GDP ratio to 48.15 percent, a ratio surpassed only in 1944 and 1945.
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Those expecting an economic recovery as the inevitable result of this increase in government spending would do well to look at what happened in those two years. The depression had ended four years previous, but despite G accounting for half of GDP, the U.S. economy only grew from $219.80 billion in 1944 to $222.30 billion in 1946, an annual growth rate of one-half percent. Not until government spending began to dramatically fall, as low as 20 percent in 1948, did Americans see the astounding double-digit growth that characterized the post-war economic expansion.
There are two significant factors left out by those expecting expansive fiscal policy to produce recovery. The first is the fact that Americans do not have the benefit of selling their products to a world with an industrial base devastated by five years of violent military conflict. The second is that even if one assumes that increased government spending is always beneficial, the impact of the increase should only be expected to be half what it was in the 1940s due to the delta from the average of the previous 10 years being 13 percent of GDP compared to a 25 percent historical delta. The Friedmanite portion of the modern synthesis has failed, now it is the Keynesian aspect's turn to do the same.