By Peter G. Gosselin From the Los Angeles Times

January 11, 2009

Reporting from Washington — In a measure of how quickly its options are shrinking, the United States is about to embrace an economic theory that was widely thought for most of the last generation to have been discredited: the idea that great bursts of deficit-funded government expenditure can jolt an economy back to growth.

And the nation is poised to put this theory to the test on a scale untried in peacetime by any developed country on Earth.

President-elect Barack Obama will soon unveil a package of tax cuts and spending increases that, combined with already planned spending, would push Washington's 2009 deficit to between $1.5 trillion and $2 trillion -- more than 10% of the economy's output. And he will argue that this tidal wave of federal expenditure should continue into next year, and perhaps beyond.

Only during World War II did U.S. government expenditures account for a greater share of economic activity, according to federal statistics. That's also true for virtually every other developed country.

"There's been nothing of the magnitude of what the incoming administration is contemplating -- certainly not as intentional policy -- in the modern era," said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington.

The sheer size of Obama's plan and the considerable support it is generating among economists as well as the public are testament to the frightening dimensions of the global economic plunge -- and to the fact that, to date, efforts by government policymakers have done little more than slow the fall.

Obama's plan represents an unexpected comeback for the ideas of the late British economist John Maynard Keynes, who argued in the 1930s that governments could end the Depression by spending heavily to maintain demand for goods and services until frightened consumers and damaged businesses gained the courage to resume buying and selling on their own.

The secret, Keynes argued, was not so much the amount of money the government spent, but how convincingly it signaled that the economic game was reviving -- and thus enticed players in the private sector to overcome their fears and begin playing again.

In this regard, timing and the political atmosphere when the government acted were critical: The size of the stimulus had to be large enough to seem likely to have an effect, and action had to be taken quickly and decisively -- without the kind of political haggling that could undermine confidence.

Experience also suggests the stimulus strategy must be accompanied by steps to fix the damaged financial system, especially credit, economists say.

"If you don't fix the financial system, you're going to linger in the wind for a very long time," said Harvard economist Kenneth Rogoff.

For decades, conservative economists have dismissed Keynes as misguided. What has suddenly revived interest in his ideas is the shattering speed with which the present economic crisis has developed.

At the American Economic Assn.'s annual meeting in San Francisco last week, experts conceded that they had been caught flat-footed by the virulence of the current crisis and were rushing to brush up on Keynesian "fiscal stimulus."

"Fundamentally, we're facing a whole new ballgame," said Boston College economist Peter Gottschalk. "We thought we knew how to treat the disease of recession. We were able to give it the right medicine and basically had it under control.

"Now we've discovered there's a new strain of the disease that requires a different kind of treatment, and our understanding of that treatment is very limited."

International Monetary Fund policymakers are urging nations to raise government spending by about 2% of their economic output -- a combined total of several trillion dollars -- to combat the global downturn. China announced last month a $586-billion package, which amounts to about 8% of its output. South Korea and Taiwan each have promised packages amounting to 4% of national output, and the European Union is considering a plan worth roughly $250 billion.

Critics of fiscal stimulus complain that government spending is invariably wasteful because it must occur quickly to prop up the economy, and that the resulting deficits eventually drive up interest rates, crowding out more-efficient private-sector investment.

But with the U.S. facing perils unseen since the Depression, the incoming administration is looking to President Franklin D. Roosevelt, the New Deal and Keynesian economics for inspiration. Indeed, in a major speech last week, Obama seemed to echo FDR's central questions: how a nation with so many needs and resources could find itself producing less, not more, and what was to be done about it.

The president-elect declared that his stimulus plan would recognize "the paradox and the promise of this moment -- the fact that there are millions of Americans trying to find work, even as, all around the country, there is so much work to be done."

Obama aides surprised some observers last week by revealing that about 40% of the stimulus package would take the form of tax cuts rather than direct spending. Several studies of recent tax cuts have concluded that those receiving them pocketed much of the money instead of spending it, dampening the growth-spurring effect.

But Obama also has promised the biggest public works initiative since the construction of the interstate highway system in the 1950s, as well as programs to repair schools, expand Internet access, make public buildings more fuel-efficient, spur growth of a renewable-energy industry, and modernize the nation's electric power grid.

Those efforts would hark back to FDR undertakings, including the notable Works Progress Administration program, which put millions of Americans to work on giant projects such as the Grand Coulee Dam in Washington state.

Although Keynes' name is indelibly intertwined with FDR's, Roosevelt did little Keynesian deficit spending during the 1930s.

"It wasn't until 1937 that he'd intellectually accepted deficit spending as a means of combating the Depression, and then there was a lot of timidity on his part about using the idea," said Stanford historian David M. Kennedy, whose book "Freedom From Fear" is widely considered the definitive account of the era.

Roosevelt's 1937 budget included a mere $3 billion of deficit spending, which amounted to 3% of national output, or less than a third of the proportion Obama is prepared to call for -- totaling about $800 billion.

It was World War II that settled the question of whether the economy could survive large government deficits and, as Keynes asserted, prosper. By 1943, deficit spending grew to more than 30% of gross domestic product. The U.S boomed during the war and, after a brief but frightening recession in 1945, it expanded powerfully.

Keynesian fiscal stimulus became such an entrenched idea that governments around the world used it to spur growth. But from the heyday of Keynesianism to the present, no country has attempted an experiment anywhere near as audacious as what Obama now proposes.

For example, spending under the post-World War II Marshall Plan, which sparked the rebuilding of war-wrecked Europe, never amounted to more than 5% of recipient nations' GDP, according to Tyler Cowen, a George Mason University economist.

And with Ronald Reagan's election in 1980, the goal became to shrink government, not expand it. Management of the economy had been largely transferred to the Federal Reserve and monetary policy. By the 1980s, recessions and serious economic turmoil seemed to be troubles of the past.

Until now.

The fundamental argument for the huge stimulus has little to do with analysis of past plans or economic theories. What's driving it is the fact that the U.S. and most other countries are in a largely unforeseen and terrifying mess.

Other than waiting for the problem to burn itself out, the new administration sees few alternatives but to return to Keynes and stimulus.