Why Deficit Stimulus Spending Doesn’t Fix Recessions, Part 1 of 2

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff explains in two columns why government deficit “stimulus spending” won’t get China out of its problems and why it’s failed over and over throughout history.

The Economics Correspondent has commented several times that China’s attempts at “fiscal stimulus”—that is, the government borrowing and spending vast amounts of money to reverse the economic downturn—will ultimately fail and that the longer Beijing implements stimulus the longer stagnation or at minimum historically very slow growth will persist.

In fact, the Correspondent thinks China’s borrowing and blowing money on stimulus measures is the best thing its competitors can hope for: a kind of self-immolation of the Chinese economy. Hence he’s offered to buy a business class seat for Paul Krugman to visit Beijing and serve as China’s economic advisor for the next decade.

But why this the conviction that stimulus fails?

The answers are both historical and theoretical. In this first of two columns we’ll cover the notable historical failures of government stimulus.

1) Historically, stimulus in response to an endogenous economic downturn has failed every time it’s been tried. The more deficit stimulus spending, the longer the downturn drags on.

Even though British economist John Maynard Keynes famously advocated stimulus spending in his 1936 book “The General Theory of Employment, Interest, and Money,” the first great deficit stimulus experiment actually preceded him by seven years—at the start of America’s Great Depression.

President Herbert Hoover responded immediately to the 1929 stock market crash with a rash of interventionist measures including fiscal stimulus. In his four years in office Hoover doubled federal spending (when adjusted for inflation), and the deficit grew from a surplus of 0.8% of GDP in Calvin Coolidge’s last budget to a deficit of 5.8% of GDP in Hoover’s last budget.

By the time Hoover left office the economy was in shambles with 26% unemployment, although the great banking crisis of early 1933 was a major contributor to that astonishingly high unemployment rate as well.

Franklin Roosevelt continued to borrow and spend on stimulus, running a deficit for every one of his 12+ years in office, something unheard of at the time.

Result? The depression dragged on for another 13 years, only ending in 1946. In 1940 unemployment was still over 15%, far higher than in 1930.

Even with all that stimulus spending the Great Depression lasted nearly three times longer, as measured by time required to return to private full employment after a financial crisis, than the next longest depression in American history.

Some Keynesian economists claim the economy recovered in 1946 because for the first decade-plus the government just didn't borrow and spend enough, but starting in 1942 it finally did what was necessary: borrow and spend Herculean amounts of money to pay for World War II and balloon the national debt from 44% of GDP to a record 119% in four years.

This is an odd argument considering deficit stimulus spending never existed as a policy or even an economic theory prior to 1929, yet every other preceding depression in American history (and there were several of them) ended in, at longest, one-third the time.

The Keynesians also leave out that FDR effectively ended his New Deal during World War II and finally stopped crushing American business with strangling regulations—because he needed them to function properly and deliver record numbers of tanks, planes, and ships—and *that* is what really ended the depression.

The Correspondent has previously written in detail about what ended the Great Depression in several articles including this one:

https://www.cautiouseconomics.com/2019/06/the-great-depression-15.html

2) Japan suffered from the mother of all cheap money asset bubbles in the late 1980’s which burst in 1990. At its peak Tokyo's real estate was worth more on paper than all of America’s real estate, Japan’s real estate was worth more on paper than the rest of the planet, and the Japanese stock market’s capitalization was greater than the United States’ stock market capitalization despite Japan’s economy being less than 40% the size of the USA’s.

Then the bubble burst and created a financial crisis and the Japanese government responded with the mother of all stimulus packages: nearly three decades of borrowing and spending on every government program imaginable.

From 1990 to 2024 Japan went from one of the most fiscally sound OECD governments to worst debt-to-GDP ratio on earth: from about 65% to 264% which is worse than Venezuela, Sudan, and Greece.

(For reference the USA’s now-record debt-to-GDP ratio is 121%).

34 years later Japan is widely acknowledged as having endured three decades of stagnation, the so-called “three lost decades.” In fact Japan is already being cited as a story China might repeat: building up an export-driven economy with cheap central bank money and too much debt.

If China responds the same way Japan did, with years or decades of fiscal stimulus, the story is even more likely to repeat itself.

3) When the 2008 financial crisis struck the Obama administration responded with classic fiscal stimulus: borrowing and spending over 8% of GDP for three straight years, then 6.7% and 4.1%, and swelling the national debt from $10.7 trillion to $19.8 trillion—nearly double—in eight years.

The result was not only the second longest recovery to full employment in American history (only faster than the Great Depression), but the eight year annualized economic growth rate from the crisis was by far the slowest ever in American history: an average of 2.1% per year versus anywhere from 3.5% (after the Panic of 1907) to 5.3% (after the Panic of 1893).

More details on how Obama’s record slow recovery compared to all the others are available at:

https://www.cautiouseconomics.com/2018/09/macroeconomics-01.html

Also forgotten but laughable was Obama’s prediction that (paraphrasing) “If you pass this stimulus budget, unemployment will fall to 5.6% by 2012, but if you don’t pass it unemployment will remain much higher.”

The attached chart shows the famous two blue lines that Obama's economic team sold the public and which the media first lauded but has since buried.

The dark blue line represents how quickly Obama claimed unemployment would come down with his stimulus package and the light blue line represents the horrible predicted consequences of not passing his stimulus.

The red-dotted line was added later based on actual unemployment figures, obviously not added by Obama’s team. The evidence showed with stimulus the result was worse, far worse, than even the alleged bad consequences of passing no stimulus at all.

The pro-Obama media obviously never published the revised chart, and when confronted with why unemployment remained stubbornly high Keynesian (pro-stimulus) economists and Obama himself said (paraphrasing) “We didn’t realize how bad the recession was and the stimulus just wasn’t big enough.”

Again, strange that in the 140 years before 1929, when stimulus was never tried, economic recovery growth rates were usually double that of Obama’s and unemployment came down far faster. In the old days the government just sat back, did nothing, and let the economy recover on its own.

4) Lastly, after the 2008 financial crisis most western European countries immediately implemented massive fiscal stimulus. This went on for three to four years until their debts grew so large that credit markets wouldn’t lend to them anymore, but in that three to four years unemployment reached Great Depression levels in the PIIGS nations (16% in Portugal, 25% in Spain, 28% in Greece).

With things getting worse, not better, the left blamed “draconian budget cuts.” According to them governments weren't spending enough and were actually slashing spending. For years the liberal U.S. and European press ran story after story about supposedly self-evident “massive austerity” in Europe although they never reported actual budget statistics.

Well the Economics Correspondent actually dug up government spending numbers from Eurostat which you can see below. 

Spoiler: By 2012 nearly every European government was spending more money, usually a lot more money, than before the crisis—all for stagnant populations and no inflation. And of the one country spending less in 2012 than 2007, the cut could hardly be considered in any way “draconian" (-0.9%).

In the second installment we’ll discuss the theory that explains why all these large stimulus measures have failed over and over.

ps. Note that all four of the previously cited economic depressions were preceded by asset bubble economies that were inflated by central bank cheap money policies, an important factor that will serve as part of the theory explaining why stimulus fails in the second column.
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British government spending:

2007: 544B pounds
2008: 576B pounds
2009: 621B pounds
2010: 661B pounds
2011: 681B pounds
2012: 688B pounds (+26.4% from 2007)

Source: hmtreasury

2) Spanish government spending:

2006: 378B euros
2007: 413B euros
2008: 451B euros
2009: 484B euros
2010: 485B euros
2011: 480B euros
2012: 493B euros (+19.4% from 2007)

Source: Eurostat

3) French government spending:

2006: 952B euros
2007: 993B euros
2008: 1030B euros
2009: 1070B euros
2010: 1095B euros
2011: 1118B euros
2012: 1151B euros (+15.9% from 2007)

Source: Eurostat

4) Italian government spending:

2006: 723B euros
2007: 740B euros
2008: 765B euros
2009: 788B euros
2010: 782B euros
2011: 788B euros
2012: 793B euros  (+7.2% from 2007)

Source: Eurostat

5) Greek governments spending

2006: 98B euros
2007: 109B euros
2008: 123B euros
2009: 128B euros
2010: 119B euros
2011: 112B euros
2012: 108B euros (-0.9% from 2007)

Source: Eurostat

6) Cypus government spending:

2006: 6.2B euros
2007: 6.6B euros
2008: 7.2B euros
2009: 7.8B euros
2010: 8.0B euros
2011: 8.3B euros
2012: 8.3B euros (+25.8% from 2007)

Source: Eurostat

7) Portuguese government spending:

2006: 73B euros
2007: 75B euros
2008: 77B euros
2009: 84B euros
2010: 88B euros
2011: 84B euros
2012: 78B euros (+4.0 from 2007)

Source: Eurostat