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Government Spending and GDP



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There is a lot of talk about what the new GDP numbers mean for the economy. As Patrick rightfully reminded us, these numbers will be subjected to corrections, and no one knows what they will look like then. But that doesn’t stop the flow of dire predictions about the economic impact of sequestration cuts [especially defense cuts] when they hit March. Here are a few thoughts on this issue:

The Q3 projections were artificially good, in part due to a large increase in government spending and defense spending in particular. As my colleague Keith Hall noted this morning, “we should basically average Q3 and Q4 together to understand where we are in econ growth.”

As George Mason University’s Garett Jones rightfully notes government spending raises GDP “by definition.” That, however, doesn’t mean that the GDP boost induced by government hiring, for instance, is real or more productive than private hiring. For private hiring to boost GDP, something valuable has to be produced: Not so for government. As he explains:

Hiring a worker who (through no fault of her own) accomplishes absolutely nothing raises GDP if the government does the hiring.  Hiring a worker who (through no fault of her own) accomplishes absolutely nothing does nothing to GDP if the private sector does the hiring. 

Why? Because GDP counts government salaries as “government expenditures” as soon as the government hires a person.  But the “consumption” and “investment” parts of GDP only count genuine purchases by the private sector (leaving the oddities of imputed spending for the coda below).  So if a private sector product spends years in the incubator, burning through thousands of person-hours of work and millions of dollars of salary–but never sees the light of day–then the product never shows up in GDP.  But if the government had hired those same workers who worked just as long on a similarly fruitless project, their labor would give a big boost to GDP. Government hiring creates GDP by definition.  Private hiring only creates GDP if the worker actually creates a product.  

The reverse is true. Reduction in government spending may cause a temporary shrinkage of GDP, but it doesn’t always mean that something valuable has been destroyed.

On a related note, when sequestration goes through, as it should, there is little doubt that some jobs, defense-contractor jobs in particular, will be lost; but it won’t be anywhere near the amount claimed by the anti-sequester advocates. What’s more, over time, some of these job losses will be offset by economic growth in other sectors due to the shift in resources. (See this excellent paper by Ben Zycher, which shows that military cuts could generally increase economic productivity and employment in the long term.)

 

Gross federal debt as a share of GDP at the end of FY 2012 was over 103 percent. That’s a serious increase from four years ago, and debt held by the public increased really fast too. Our long-term debt-to-GDP ratio is unsustainable.

 

The persistent pursuit of unsustainable policies and failures to address our debt problem may have damaging consequences. The work of economists Carmen Reinhart and Kenneth Rogoff shows that across wealthy and poor countries, the median growth rates for countries with publicly held gross debt exceeding 90 percent of GDP are roughly 1 percentage point lower than they would be otherwise. In their more recent paper, called “Debt Overhang: Past and Present,” they show that the reduction in GDP happens even if there is no increase in interest rates on the existing debt. The U.S. may be a better position than say, Europe, but our debt levels are entering a dangerous zone that must be addressed now. 

 

The good news is that the work of Alesina, Ardagna, and other economists has shown that austerity packages based mostly on spending cuts are very effective at reducing the debt-to-GDP ratio, and they are also associated with mild and short-lived recessions. Moreover, spending-based fiscal adjustments accompanied by supply-side reforms, such as goods- and labor-market liberalization, readjustments of public-sector size and pay, public-pension reform, and other structural changes can sometimes have positive impact on economic growth. This is less likely today, in part because export-led growth is unlikely when most of the world’s economies are hurting, but it’s worth noting nonetheless. By contrast, as Garett Jones noted recently, austerity done through tax increases hurts the economy much more than the same process via spending cuts. 

To conclude, it’s important to remember that the need to address present and future debt crises by adopting sound fiscal adjustment measures is important independently of their short-term impact on growth. In fact, these measures should be pursued not because we hope for a quick economic-growth payoff, but because they are desirable from a structural standpoint and may even help avoid future fiscal crises. 



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