The Corner

The ‘Fiscal Drag’ Folly

The fine folks at Goldman Sachs have once again let their ideology slip out — or their economics slip up. According to a widely reported analysis championed by opponents of federal spending cuts, the $61 billion cut from federal spending in the recently passed House continuing resolution would slow the economy by between 1.5 and 2 percentage points in the second and third quarters of this year. This conclusion is not only wrong, but if Goldman Sachs really believed their own analysis, they would be forecasting a deep recession for 2012.

Why a recession? The theory behind their concerns regarding the $61 billion cut centers on “fiscal drag,” which is the flip side of demand-side stimulus. The idea behind Obama’s stimulus policy was to boost the deficit dramatically, ignore that deficit spending has to be financed, and pretend that government can magically create new demand. The idea behind fiscal drag is the converse — if the deficit as a share of the economy falls, then the government is providing a net drag on the economy.

But wait a minute. The president’s budget, released last week, has the deficit dropping from 10.9 percent of GDP in 2011 to a mere 7 percent of GDP in 2012. That represents more than $610 billion worth of fiscal drag by Goldman’s lights, ten times more than the spending cuts passed by the House.

If a measly $61 billion in cuts can shave a half a point off the growth rate for the year, then wouldn’t ten times as much fiscal drag produce ten times as much economic slowdown? Wouldn’t Goldman’s analysis mean the economy would grow 5 percentage points slower? The Congressional Budget Office (CBO) is forecasting 2.8 percent real growth in 2012, so this Goldman theory means a 2.2 percent contraction for the entire year — almost as deep a recession as the one from which we just emerged.

To be fair to Goldman Sachs, their inconsistency is no worse than that of the Obama administration, which also embraced demand-side stimulus and now ignores these same forces in their economic forecast when the fiscal forces reverse. Likewise, the CBO continues to employ economic models that assume demand-side stimulus works, which is why the CBO continues to issue laughable reports claiming that Obama’s stimulus made a real difference.

As much as they might like to, the Obama administration, the CBO, and Goldman Sachs cannot have it both ways. Either the theory of fiscal drag is valid, in which case they should be forecasting a deep recession next year as the budget deficit falls substantially, or the theory of fiscal stimulus and fiscal drag is wrong and the economy should continue to recover under its own steam.

As is now increasingly obvious, the theory of demand-side stimulus and fiscal drag is wrong. The House was right to cut the spending. It’s time for the Senate to match the House’s efforts and the president to stop punting on the deficit and show a little leadership to match his fine rhetoric.

J. D. Foster is Norman B.  Ture senior fellow in the economics of fiscal policy at the Heritage Foundation.

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