Empirical study: increased spending leads to poorer economy

[Surlethe]

Harvard Business School article

Recent research at Harvard Business School began with the premise that as a state's congressional delegation grew in stature and power in Washington, D.C., local businesses would benefit from the increased federal spending sure to come their way.

It turned out quite the opposite. In fact, professors Lauren Cohen, Joshua Coval, and Christopher Malloy discovered to their surprise that companies experienced lower sales and retrenched by cutting payroll, R&D, and other expenses. Indeed, in the years that followed a congressman's ascendancy to the chairmanship of a powerful committee, the average firm in his state cut back capital expenditures by roughly 15 percent, according to their working paper, "Do Powerful Politicians Cause Corporate Downsizing?"

"It was an enormous surprise, at least to us, to learn that the average firm in the chairman's state did not benefit at all from the unanticipated increase in spending," Coval reports.

Over a 40-year period, the study looked at increases in local earmarks and other federal spending that flowed to states after the senator or representative rose to the chairmanship of a powerful congressional committee.

We asked Coval about the relationship between the government and the private sector, and how policymakers should critically evaluate federal stimulus plans to help local companies.

Sean Silverthorne: First, a little bit about your empirical approach to the research. Why did you decide to study changes in congressional committee chairmanships?

Joshua Coval: Our original goal was to investigate how politically connected firms benefit from increases in the power of their representatives. A benefit in focusing on changes in committee chairmanships is that their timing is largely exogenous from the perspective of the ascending chairman and his constituents. That is, a change in chairmanship can only occur if the incumbent retires or is voted out--both of which are entirely independent of what is currently happening in the ascending chairman's state.

Q: One of your findings was that the chairs of powerful congressional committees truly bring home the bacon to their states in the forms of earmark spending. Can you give a sense of how large this effect is?

A: Sure. The average state experiences a 40 to 50 percent increase in earmark spending if its senator becomes chair of one of the top-three committees. In the House, the average is around 20 percent. For broader measures of spending, such as discretionary state-level federal transfers, the increase from being represented by a powerful senator is around 10 percent.

Q: Perhaps the most intriguing finding, at least for me, was the degree and consistency to which federal spending at the state level seemed to be connected with a decrease in corporate spending and employment. Did you suspect this was the case when you started the study?

A: We began by examining how the average firm in a chairman's state was impacted by his ascension. The idea was that this would provide a lower bound on the benefits from being politically connected. It was an enormous surprise, at least to us, to learn that the average firm in the chairman's state did not benefit at all from the increase in spending. Indeed, the firms significantly cut physical and R&D spending, reduce employment, and experience lower sales.

The results show up throughout the past 40 years, in large and small states, in large and small firms, and are most pronounced in geographically concentrated firms and within the industries that are the target of the spending.

Q: Although you didn't intend to answer this question with the research, what does your team suspect are some of the causes that could explain why companies retrench when federal dollars come into their neighborhoods?

A: Some of the dollars directly supplant private-sector activity—they literally undertake projects the private sector was planning to do on its own. The Tennessee Valley Authority of 1933 is perhaps the most famous example of this.

Other dollars appear to indirectly crowd out private firms by hiring away employees and the like. For instance, our effects are strongest when unemployment is low and capacity utilization is high. But we suspect that a third and potentially quite strong effect is the uncertainty that is created by government involvement.

Q: These findings present something of a dilemma for public policymakers who believe that federal spending can stimulate private economic development. How would you suggest they approach the problem that federal dollars may actually cause private-sector retrenchment?

A: Our findings suggest that they should revisit their belief that federal spending can stimulate private economic development. It is important to note that our research ignores all costs associated with paying for the spending such as higher taxes or increased borrowing. From the perspective of the target state, the funds are essentially free, but clearly at the national level someone has to pay for stimulus spending. And in the absence of a positive private-sector response, it seems even more difficult to justify federal spending than otherwise.

Q: What do you think your research has brought to the literature?

A: The literature has had difficulty empirically identifying the effect of government spending on the private sector. Because spending both influences and is influenced by developments in the private sector, disentangling the two has proven challenging. We think our approach offers a rare opportunity to identify the private-sector response to government spending increases that are essentially random.

Q: What are you working on next?

A: Our next project will be to ask a similar question of the private sector: Does private-sector economic activity create or crowd out additional private-sector opportunities? Put differently, did Bill Gates's decision to relocate Microsoft to the Seattle area in 1979 increase the likelihood that Amazon.com, Starbucks, and Costco would emerge from there a decade or so later? If so, this has strong implications for policymakers interested in, say, improving Detroit's economic prospects.

Very interesting. This is leading me to provisionally question stimulus spending.

[The Duchess of Zeon]

Before you do that further studies are needed on whether or not the benefits of public control of projects after their completion outweight the depression of corporate development. Still, the idea that corporate welfare is completely useless is hardly an inobvious one.

[The Spartan]

I can't seem to find it, but wasn't there a study posted to the board, possibly sometime around the time the bank bailout was being debated, that showed that government spending introduced more money to the economy than tax cuts? Something like $0.75 got into the economy from $1 of tax cuts, but government spending got $1.25 into the economy for every $1 spent. I may have the numbers wrong, but the gist of what I'm saying is correct if I'm remembering right.

The reason I ask is that this study seems to contradict it. Does anyone else remember the study I'm thinking off?

[Phantasee]

From my perspective, I don't think the purpose of stimulus spending is to promote economic growth, so much as just help tide firms over until regular economic activity resumes. If th government wasn't throwing around all this cash for infrastructure projects, my family business would probably have been fucked. As it is, we're getting by, and we'll probably make it to the point when private projects start up again.

But that's from the perspective of a small business.

[Samuel]

It was an enormous surprise, at least to us, to learn that the average firm in the chairman's state did not benefit at all from the increase in spending. Indeed, the firms significantly cut physical and R&D spending, reduce employment, and experience lower sales.

The results show up throughout the past 40 years, in large and small states, in large and small firms, and are most pronounced in geographically concentrated firms and within the industries that are the target of the spending.

That doesn't sound like firms are hurting- it sounds like firms are using the free money to increase their profits. If you guarentee income, incentives to compete go down and so they don't have to invest as much money or effort into dealing with outside firms.

This isn't comparable to broad based economic stimulus (although it should have an effect by making foreign firms less of a threat), but this seems similar to the problems faced by import substitution.

Something like $0.75 got into the economy from $1 of tax cuts, but government spending got $1.25 into the economy for every $1 spent. I may have the numbers wrong, but the gist of what I'm saying is correct if I'm remembering right.

The reason I ask is that this study seems to contradict it. Does anyone else remember the study I'm thinking off?
I can't seem to find it, but wasn't there a study posted to the board, possibly sometime around the time the bank bailout was being debated, that showed that government spending introduced more money to the economy than tax cuts? Something like $0.75 got into the economy from $1 of tax cuts, but government spending got $1.25 into the economy for every $1 spent. I may have the numbers wrong, but the gist of what I'm saying is correct if I'm remembering right.

The reason I ask is that this study seems to contradict it. Does anyone else remember the study I'm thinking off?

Yes. I don't have a link, but I know what you are talking about. It is based on the fact government has a different marginal rate of consumption than the populance. I forget if it is supposed to be larger (so the multipler effect is more pronounced and the economy expands) or smaller (so the government is better at allocating resources to investment).

[J]

I can't seem to find it, but wasn't there a study posted to the board, possibly sometime around the time the bank bailout was being debated, that showed that government spending introduced more money to the economy than tax cuts? Something like $0.75 got into the economy from $1 of tax cuts, but government spending got $1.25 into the economy for every $1 spent. I may have the numbers wrong, but the gist of what I'm saying is correct if I'm remembering right.

The reason I ask is that this study seems to contradict it. Does anyone else remember the study I'm thinking off?

That would probably be the CBO's Report on the ARRA which had a table of the multiplier effects of various spending programs. In the CBO report, it was assumed from the models that the crowding out and offsetting of private sector investment by government stimulus funds was likely negligible (see page 6 of the report). Note that they didn't do an empirical study on it, this was an assumption made from their various economics models.

[The Spartan]

From my perspective, I don't think the purpose of stimulus spending is to promote economic growth, so much as just help tide firms over until regular economic activity resumes. If th government wasn't throwing around all this cash for infrastructure projects, my family business would probably have been fucked. As it is, we're getting by, and we'll probably make it to the point when private projects start up again.

But that's from the perspective of a small business.

There's also the other report, from the GAO I think, that says that things would have been worse without the Stimulus bills.

Consider what would have happened if the Big Three had been allowed to go under when they employ, directly and indirectly, 10% of the American work force. You'd have had a stated unemployment of something closer to 20%* compared to the 10% or so that it peaked at with a real unemployment closer to 25% or 30%.



*Well, probably not exactly that (ditto the other numbers, they're more illustrative than anything else), but even jumping to 15% reported would have been far worse. Oh, and by 'x% reported' I mean what the government says unemployment is as opposed to the actual number of people who are out of work which is actually a larger number.

[The Spartan]

That would probably be the CBO's Report on the ARRA which had a table of the multiplier effects of various spending programs. In the CBO report, it was assumed from the models that the crowding out and offsetting of private sector investment by government stimulus funds was likely negligible (see page 6 of the report). Note that they didn't do an empirical study on it, this was an assumption made from their various economics models.

Emphasis added.

That's the part I didn't remember. If I'd kept in mind it was from their various models rather than an empirical study, I'd have been more skeptical of those numbers compared to these.

[Shroom Man 777]

If the government didn't stimulate the economy, wouldn't the forces of the free market inevitably ensure a good outcome when the bad bankrupt companies die and are replaced by those with superior capitalistic entrepreneurial prowess?

[Illuminatus Primus]

"Increased spending" means, increased spending of a particular sort. Is it really surprising pork is more politically productive than economically productive. I don't see how state capitalist industrialization and modernization and pro-growth packages throughout history can be criticized on the basis of this.

[SirNitram]

This, ESPECIALLY the emphasis-added parts, talk only about the effects of pork-barrel earmarking for special interests, not stimulus spending outside of that. What that says to me, in absense of further studies(And I definitely support more) that we need to pursue earmark reform so that it's less handouts to friends and more effective spending for your home state.

And more trains. Because everywhere needs quality train service.(This last sentence not entirely serious. Your Beliefs May Vary.)

[The Guid]

If the government didn't stimulate the economy, wouldn't the forces of the free market inevitably ensure a good outcome when the bad bankrupt companies die and are replaced by those with superior capitalistic entrepreneurial prowess?

Why wouldn't this have happened? Say the Big Three failed, surely somebody somewhere would want to take on their role of lenders - as initially they'd have little competition, and could charge interest pretty much as they wanted.

I presume it wouldn't have happened, I just don't think I properly understand why.