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Tuesday, August 4, 2009
10:35 AM EDT
Tim Andrews

Stimulus Economics: A Historical Case Study

It is a rather standard practice in science. It’s called hypothesis testing. You take two identical subjects. You perform action A on one, and action B on another. Then you measure the results.
 
Imagine if we could do that with economies. Take two economies in an identical situation, and test the impact of different government policies on them. It would be the perfect experiment! We could, for instance, find out whether or not stimulus spending actually works or not! Well, we’re in luck.
 
As Professor Sinclair Davidson, from the Royal Melbourne Institute of Technology, noted last week, such a case does exist. The data is there. In 1930, both Australia and the United States were in an identical situation following the worldwide economic collapse. The stock market plummeted, unemployment skyrocketed, and the economy was in crisis. Yet both governments responded in a totally different manner.
 

The United States, under President Hoover, rapidly increased government spending in real terms by over 70% between 1930 and 1932 (from $2.7b to $4.7b, adjusted for deflation), despite revenue collapsing by over 40% ($3.3b. to $1.9b, adjusting for deflation). The goal? Stimulating the economy. By 1934, US. Government spending had increased a whopping 250% over 1929 levels. In contrast, the Australian government in August 1930 resolved to cut Federal spending by 20%, and restore a balanced budget.

As such, it is clear that 1931 is the year the policies diverge. From the beginning of the year, the U.S increases spending by 45%, Australia cuts it by 15%.  If the fundamental theory underpinning ‘stimulus’ economics holds, we should see, almost immediately, a change in outcomes. Australia’s GDP should decrease, whilst GDP should increase in the U.S. Similarly, unemployment should go up in Australia, and fall in the U.S. 

So.
 
Let's see what happened.

Australia’s GDP starts to grow. In the U.S it continues plummeting.

In fact, almost immediately after Australia resolved to slash the size of government, its GDP began to rise.

I can not stress this enough: in the year that US Government spending increased 45%, GDP fell a whopping 17%. I repeat, 17%. In Australia, where government spending fell 15%, GDP increased 5%. In the following year, while the U.S “stimulated” economy fell 2%, Australia’s grew a whopping 7%.

While the U.S economy eventually begins to improve, as the business cycle kicks in, it does so at a considerably delayed rate to Australia, where the government did not crowd out the private sector thereby delaying the recovery.

There could be no better example of how the economics behind ‘stimulus’ packages fail.

 Now let us look at unemployment rates. Again, please note, the critical year here is 1931, the year the two countries diverged in policy.

 
Again, from 1931-1932 unemployment index in Australia stabilizes, while in the US it increases almost 8%. Whilst the US rate begins to stabilize the following year, it is clear from the Australian experience that this would have occurred faster, and more effectively, without the stimulus. Not captured here is the fact that Australia had double the U.S rate of unemployment to begin with, and in 3 years had less than half.
 
There is a reason why Henry Morgenthau – FDR’s very own Treasury Secretary from 1934-1945 said “we have tried spending money.  We are spending more than we have ever spent before and it does not work. . . . I say, after eight years of this administration, we have just as much unemployment as when we started . . . and an enormous debt to boot.”
 
So. To summarize. In 1930 the U.S and Australian governments, when faced with an identical situation, responded in different ways. The U.S tried a ‘stimulus’, Australia tried cutting government.
 
The U.S. government policy failed. Abysmally. On every indicator. The Australian approach worked.
 
The facts don’t lie.

(Note: The Institute of Public Affairs last week released a paper entitled "Five and a half big things Kevin Rudd doesn't understand about the Australian economy" which discusses the Australian economic climate during the Great Depression in greater detail)

Posted by Tim Andrews on Tuesday, August 4, 2009 10:35 AM EDT
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