The Data
Chapter 9 from my forthcoming book "Money and Macroeconomics from First Principles, for Elon Musk and Other Engineers"
One key takeaway from the preceding chapters is that both the conventional and the folk wisdom on how the economy operates are wrong. This is apparent in the data.[1] Conventional wisdom on the economy—which is taught in economic textbooks—implies that a capitalist economy performs best with minimal government intervention. Folk wisdom blames the Federal Reserve for causing inflation.
Instead, economic growth has been substantially faster since the establishment of The Federal Reserve, and since the evolution of “Big Government”, which commenced during WWII. The average rate of inflation has been much higher since both The Fed and Big Government, but this has happened because deflation, which was a regular experience in pre-WWII data, has been all but eliminated—see Figure 39. In fact, price volatility was higher before Big Government: the highest rates of inflation were recorded during the 19th century, but they were offset by prolonged bouts of deflation. Deflation was in turn a key factor in the regular Depressions—including the Great Depression—which occurred before Big Government.
Figure 39: US Economic Performance since 1790
The aggregate data in Table 8 shows that the best performing period, in terms of annual growth in real per capita GDP, was the post-WWII period, when it averaged 1.86% p.a., versus 1.38% p.a. in the pre-WWII period (the equivalent growth performance both after the Fed’s formation and between the World Wars includes the huge increase in military spending for the Wars, offset by the collapse in growth during the Great Depression). This coincides with federal government spending averaging 17% of GDP, versus the 3% level that applied from 1790 till 1913. The average post-WWII surplus was minus 4.4%—in other words, the government has on average spent 4.4% of GDP more than it has taxed for the post-WWII period.
Table 8: USA Economic Indicators over time. All numbers are percentages
The conventional and folk wisdom both assert that high levels of government spending, and especially high levels of government deficits, will harm the economy. The data begs to differ: leaving aside distributional and climatic issues, the ultimate arbiter of the economy’s performance is per capita economic growth. Annual per capita growth has been about 0.5% higher under Big Government and sustained deficits than it was under Small Government and balanced budgets. This implies that there has been a higher level of aggregate investment, and therefore a higher level of capital formation, with Big Government and sustained deficits, than there was with small government and no deficits.
Data versus Dogma
This empirical result is the opposite of what one would be led to expect by economics textbooks. Mankiw’s Macroeconomics textbook asserts that budget deficits reduce private investment:
a budget deficit raises interest rates and crowds out investment; the resulting reduction in the capital stock is part of the burden of the national debt on future generations. {Mankiw, 2016 #6107, p. 253}
That the empirical results are the opposite of what economics textbooks teach is of little wonder since, as previous chapters have shown, textbook models of banking are structurally and logically false. Mankiw’s reasoning which led to this assertion was based on the Loanable Funds model of lending, which itself is a fallacy.
This is not an isolated phenomenon. In numerous areas of economics, the empirical data strongly contradicts the theory. There is something congenitally wrong with economics, something peculiar about it which leads to counterfactual assertions being routinely made by economics textbooks and those influenced by them. Dogma dominates data.
I cover the reasons for this in detail in my book Debunking Economics {Keen, 2011 #2701}. In this book, I have covered why Neoclassical economics is profoundly wrong about money and banking. The next chapter provides one additional example, which is of great relevance to engineers: how economists fail to account for the role of energy in production.
[1] The data in Figure 39 come from https://www.measuringworth.com/index.php.