Do Firms Retrench as Government Spending Increases?

The Harvard Business School Working Knowledge site profiles a fascinating new study by finance professors Joshua Coval, Lauren Cohen, and Christopher Malloy. The research examined the effect on local firms when a legislator from that state rose to a powerful chairmanship in Congress. Not surprisingly, these scholars found that, "The average state experiences a 40 to 50 percent increase in earmark spending if its senator becomes chair of one of the top-three congressional committees. In the House, the average is around 20 percent."

Much more surprisingly, however, the research shows that, "In the year that follows a congressman's ascendancy, the average firm in his state cuts back capital expenditures by roughly 15 percent." What's happening? Federal spending appears to be crowding out private investment to a very large degree. The professors offer three possible explanations. In some cases, the government spending directly supplants private investment. Second, federal projects may hire away talented employees and secure other resources that private firms need to expand. Third, the heavy government involvement in the local economy may create high uncertainty, making private firms much more hesitant about making large capital investments.

Remember that this study does not even take into account the negative effects of the taxation required to pay for these government projects. The scholars certainly should give us pause as we consider whether stimulus funds can bring the economy back from its doldrums, as well as whether government efforts can truly drive local economic development to the degree many officials often expect.