The Impact of Spending Cuts on the Economy

by Veronique de Rugy

According to Alec Phillips, an analyst at Goldman Sachs, the spending cuts passed by the House last week would hurt the economy if enacted:

Under the House passed spending bill, the drag on GDP growth from federal fiscal policy would increase by 1.5pp (percentage points) to 2pp in Q2 and Q3 compared with current law.

Given the failure of the stimulus bill to reduce unemployment or fulfill the other predictions made about its economic effects, I find it strange that people would believe this prediction, but we will certainly continue to hear over and over that cuts in government spending will reduce GDP.

Part of this has to do with the way gross domestic product is measured. First of all, GDP numbers include government spending, not transfers (unless they are spent), so when the government pumps thousands of billions of dollars into the economy, it looks as if GDP is growing. The reverse is also true: When spending is cut, it looks like GDP is falling.

What’s more, the way the GDP accounts for government spending is biased: It assumes that if the government spends $200,000 on a contractor to repave a road, it creates $200,000 of genuine economic value. GDP measurement is tougher on private-sector spending. As my George Mason colleague Garrett Jones explained it to me, “If Exxon Mobil pays an engineer $200,000 per year, that only shows up in GDP if the engineer finds an extra $200,000 of oil to sell, or builds a new machine that sells for $200,000, something like that.” The GDP doesn’t capture any changes in personal stock benefits, either. It doesn’t capture changes in things like research and development spending, so the cuts in this area have been large but unaccounted for. Also not included in the GDP figure are pension benefits and the U.S. Flow of Funds Accounts balance-sheet information from the Federal Reserve Board.

The way we measure GDP means that any cuts — even cuts in the most inefficient programs — make it look as if GDP is falling as a result. It will make any spending look like it is growing the economy. When the spending stops, GDP goes back down — but we are saddled with loads of debt.

Maybe more importantly, models used by economists (on each side of the aisle, by the way) just aren’t very good predicting the future with any precision, especially when it comes to jobs. Remember how, in November of 2010, the CBO models showed that ARRA had created between 1.4 and 3.6 million extra jobs? These were the same models that had predicted before ARRA’s passage that this same number of jobs would be created if the money was spent. As I have mentioned before, those models are broadly based on the Keynesian notion that government spending leads to recovery — and, as my colleague Russ Roberts told Congress last week, “In the Keynesian worldview, paying workers to dig holes and fill them back in promotes recovery.” He added:

When the upper limit of your estimate is almost three times the lower limit, you know it is not a very precise estimate. But there is no way and there will never be a way to make that estimate any more precise. And there is no way of knowing if the real number falls within this absurdly large range. To do so would require using the actual data on output and employment while holding other factors constant. The CBO did not use those data. Why not?

The CBO in their November 2009 estimates of the impact of the stimulus spending said that “because isolating the effects would require knowing what path the economy would have taken in the absence of the law. Because that path cannot be observed, the new data add only limited information about ARRA’s impact.”

The truth is that these models cannot accurately predict the effect of government spending on job creation. It is likely that no models can. As Roberts has written, “The economy is too complex. Too many other variables change at the same time.”

One thing we do know, however, is that the promises lawmakers made before the stimulus money was spent didn’t materialize. We know this because we can observe it: Unemployment remains high — certainly it has been higher than the 8.8 percent rate that the administration claimed we would reach if we didn’t spend the stimulus money.

What would increase employment and stimulate economic growth is investment — private investment, not government spending labeled as investment. As Stanford economist John Taylor emphasizes in forthcoming research, raising investment as a share of GDP is the best way to reduce unemployment; investment is much more strongly correlated with decreasing unemployment than any components of government spending.

So a major factor in the current American stagnation becomes plain: Companies are not investing. They are hoarding some $1.8 trillion in capital. Why? Because entrepreneurs are acting very cautiously out of fear of the future. Recent policy changes have hampered business investment, making a bad situation worse. The prospect of endless future debt and deficits raises the threats of increased taxes and government crowding-out of capital markets. Health-care and financial reforms have increased businesses’ regulatory burdens. Uncertainty prevails. As a result, U.S. companies don’t build new plants, they don’t conduct research, and they don’t hire people. People stay unemployed — for weeks, months, years.

As policymakers attempt to reduce unemployment and encourage growth, they must realize their limitations and the unrealized opportunity for private-sector growth. Lasting economic stimulus will come when they allow American businesses to thrive. Those are the points I made last week when I testified before Congress (video here, testimony here).

And remember, the CBO itself acknowledges what will happen to our economy and our GDP if we fail to cut spending today.

Update: Here is a really good blog post by my colleague Matt Mitchell with lots of academic articles about how spending cuts may stimulate the economy. In particular, he quotes David Romer’s Advanced Macroeconomics. Romer is the husband of President Obama’s former CEA chair, Christina Romer and he would probably call himself a neo-Keynesian.

[A] small reduction in current government purchases could signal large future reductions, and therefore cause consumption to rise by more than the fall in government purchases.

Surprisingly, these possibilities are more than just theoretical curiosities. Giavazzi and Pagano (1990) show that fiscal reform packages in Denmark and Ireland in the 1980s caused consumption booms, and they argue that effects operating through expectations were the reason. Similarly, Alesina and Perotti (1997) show that deficit reductions coming from cuts in government employment and transfers are much more likely to be maintained than reductions coming from tax increases, and that, consistent with the importance of expectations, the first type of deficit reduction is often expansionary while the second type usually is not.

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