The Greatest Economic Myth of the Century

by Burt on April 11, 2011

My candidate for “greatest economic myth of the century” was popularized by British economist John Maynard Keynes in the 1930s. He thought that massive government spending would halt recessions and lead to prosperity. The myth here is that government spending, i.e. the extracting of dollars from taxpayers and then handing them out to key groups by politicians, helps the economy as a whole. Keynes worded his theory this way: “To dig holes in the ground, paid for out of savings, will increase not only employment, but the real national dividend of useful goods and services.”

Keynes’s idea that government spending, even just digging holes, will lead to prosperity was discredited shortly after he announced it in 1935 during the Great Depression. Despite the highest level of peacetime government spending in U. S. history, the Great Depression persisted in the U. S., and President Roosevelt even had 20.7% unemployment in 1939, late in his second term. Never before in American history had we had double digit unemployment for a whole decade. But never before had we believed such a damaging economic myth.

How did we get out of the Great Depression? After World War II, the U. S. sharply cut government spending and slashed the top corporate tax rate from 90 to 38 percent. This anti-government spending approach worked miracles and finally triggered the recovery from the Great Depression. My book, written with my wife Anita, entitled FDR GOES TO WAR (Simon & Schuster) will be out in the fall, and in the final chapter, we describe the recovery of the U. S. from the Great Depression. The U. S. had only 3.9% unemployment in 1946 and 1947.

Keynes was right in a sense–government spending can help those groups receiving the most tax dollars. In 1932-1933 during the first federal welfare program in U. S. history, for example, the state of Illinois received more federal money than New York, California, Texas, Florida, and Massachusetts combined. Illinois, therefore, did gain from the inflow of cash from New York and the other states. But the nation as a whole did not benefit by sending more dollars out of their states in taxes than they got back from Washington. And so the Great Depression persisted. When the government engages in massive spending it has to tax its citizens (or borrow money or print it), and the economy as a whole cannot benefit.

Why do politicians persist in massive government spending? Because many interest groups see the chance to gain federal funds at the expense of others. And these targeted groups happily give their votes to the politicians who can deliver to them other peoples’ money. FDR won re-election in 1936 because of the huge spending on through the WPA, and then he won in 1940, in part by delivering large defense projects to key states whose electoral votes he wanted to secure.

The Keynesian myth that government spending works wonders is alive and well today in both political parties. In 2008, President Bush promoted a stimulus package of federal spending, but instead unemployment went up. The next year, President Obama promoted an even larger stimulus package, and unemployment went up even more to almost 10%. One of the tragedies of the myth of federal spending is that those who believe this idea, when it fails to work, conclude that they didn’t spend enough; therefore, they say, we need even more of the poison of government spending to spark economic recovery.

That helps explain the budget crisis today. President Obama’s proposed federal budget includes another flurry of spending (we apparently didn’t spend enough in 2009 and 2010), which will add another $1,500,000,000,000 to the national debt. Because so many politicians believe the myth that more federal spending is better (or maybe they just want to give cash to certain voting groups), most members of the Senate and President Obama as well talk about alleged catastrophes if the federal spigot is shut off. The lesson of the aftermath of World War II, however, is that if we cut tax rates and cut federal spending, we will encourage entrepreneurs to invest, halt the increase in destructive debt, and spark an economic recovery,

Keynes was right on one point. “Ideas shape the course of history,” he said. But now we need to replace his ideas with better ideas that work.

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