Keynesian Economics: Theory and Reality

In 2009, the United States Congress passed the American Recovery and Reinvestment Act (ARRA), more commonly known as the stimulus package. This stimulus consisted of $787 billion in public spending. A study by economists Garret Jones and Daniel Rothschild, recently published by the Mercatus Center, analyzed what happens when the theory of Keynesian economics is put into practice.

According to the Obama administration’s theory, the stimulus would “create or save” 3.5 million jobs in the two years that followed and would prevent the unemployment rate from going over 8.5 percent. In fact, they said that with the passage of the ARRA, unemployment would dip to 7.25 percent by the end of 2010. However, unemployment has remained at 9 percent or higher (except for two months) from August 2009 to August 2011.

The Keynesian theory tells us that public spending during a recession can have a “multiplier effect” in which a dollar of public spending rapidly increases the size of the economy by a dollar or more. The neoclassical theory tells us that jobs are simply transferred from the private sector to the public sector in such a way that there is no net increase in jobs. Jones and Rothschild assert that even though neither of these two characterizations is entirely accurate, there is one that is closer to reality.

The researchers interviewed managers and employees from hundreds of companies, nonprofit organizations and local governments that received funds from ARRA. Their study concludes: “Hiring isn’t the same as net job creation. In our survey, just 42.1 percent of the workers hired at ARRA-receiving organizations after Jan. 31, 2009, were unemployed at the time they were hired. More were hired directly from other organizations (47.3 percent of post-ARRA workers), while a handful came from school (6.5 percent) or from outside the labor force (4.1 percent).”

In some cases, the jobs financed through funds from ARRA would pay higher salaries, so many workers abandoned positions in the private sector to become part of the public sector.

In other cases, the pressure by the federal government to spend more quickly resulted in ridiculous cases, including one which concerned small tiles: A public contractor who installed tiles in public buildings said that he had planned to use regular four-inch tiles, but the government agency that contracted him required him to use smaller tiles in a more complicated color pattern. The contractor let them know that this would increase his costs by about 50 percent in terms of labor, but this was the only way that money from the ARRA could be spent more quickly.

In the majority of cases, the stimulus transferred employees from one organization to another instead of creating a net increase in jobs, and it did not efficiently use resources. Instead of increasing public spending, the economy would have been better off if the government had provided better incentives for people to invest more, creating new jobs and optimizing the allocation of resources.