Johnny Munkhammar: Extra government spending doesn't bring growth

Johnny Munkhammar was a Member of Parliament in Sweden for Moderate Party. A blogger and advocate of free market causes he was author of The End of Stimulus (American Enterprise Institute) and a writer for the Institute of Economic Affairs. He died earlier this month from a rare form of cancer and we believe that this article may have been the last he wrote. He leaves behind a wife and two children.

Economic growth instead of austerity! This has been the renewed call of political leaders such as Barack Obama and Francois Hollande recently. Their policy interpretation of how to achieve growth is to put government in the driving seat and increase public spending to stimulate the economy.

Even in "austerity" UK, government spending under the coalition is hardly falling and, because GDP is stagnant, government spending as a proportion of GDP is remaining harmfully high. There have been calls from within the coalition for more infrastructure spending. However, though such spending may be justified on the grounds of long-term profitability, we should not fall for the illusion that it will kick-start growth.

But how come austerity countries such as Estonia, Latvia, Lithuania - and to a large extent also Sweden and Germany - are making it out of the recession better than stimulus countries such as Spain or the United States? Here are a few explanations.

Problem number one at present with government stimulus is debt. According to a study of 44 countries, a country with a debt level of more than 90 per cent of GDP which borrows more in order to stimulate the economy will create directly counter-productive effects for growth (Reinhart/Rogoff).  Not only has Greece by far passed that level, but also countries such as Italy, Japan and the US.

EU countries that increased public spending during the past decade, and especially during the financial crisis, actually had lower growth. Only three EU countries decreased public spending (including Sweden) and they fared much better. Latvia, which went through the toughest austerity of all 27 EU countries, now has among the very highest growth rates in Europe.

The USA, with its vast stimulus program, illustrates several other disadvantages of traditional stimulus policy. The increase in spending was not timely, since much still remains to be spent four years after the financial crash that caused the initial slow-down. Neither has the stimulus that has applied been temporary - it has increased discretionary government spending by some 20 per cent and there appears little prospect of government spending reducing.

The Congressional Budget Office claimed early on that the US stimulus would crowd out private spending in the long run, thus leading to lower future GDP than without the stimulus. This was a price that policymakers were ready to pay in order to have quicker growth in the short run. The main result, however, seems to have been for U S government debt to have doubled in five years.

There are a number of reasons why government spending lowers growth. Ultimately, an increase in government spending involves increasing the size of the centrally planned relative to the de-centralized economy.

Who today thinks that government agencies can point out where the best new companies, products or jobs will emerge? By removing money from the private sector - and government borrowing does just that - and replacing private spending with government spending, we increase distortions and reduce productivity. The economy is not boosted but pulled out of shape requiring more and more painful adjustment at a later stage.

A recent summary of research into the relationship between growth and government spending concluded that ten percentage points higher government spending leads to economic growth 0.5-1 per cent lower per annum. And this matters over time - the difference between an annual growth rate at two per cent and an annual growth rate of three per cent is the difference between doubling GDP in 24 years or doubling GDP in 36 years.

Increased government spending now - especially if it includes increased deficits and debt - would be a certain way to deepen the debt crisis and lowering growth. So what should we do? As difficult as short-term crisis management is, research offers some guidance.

It is a mistake for the government to first raise taxes and only then reduce spending. The UK government still needs to reduce spending sufficiently in the next few years to ensure that taxes can be cut to attract investment and work. In an economic crisis, cries to "spend more" are frequent. It usually implies that governments should borrow on behalf of taxpayers and spend as they see fit. This policy brought us the debt crisis in the first place and would deepen it - and we get stuck with bigger government.

If we want growth - and we should - then the conclusions are that we should instead aim for liberalisations, tax cuts and lower public spending. That is what works.