There are several things wrong with the analysis used in Goldman Sachs report. First, it does not take account of the beneficial effects of starting now on a credible plan to reduce the deficit. Basic economic models in which incentives and expectations of future policy matter show that a credible plan to reduce gradually the deficit will increase economic growth and reduce unemployment by removing uncertainty and lowering the chances of large tax increases in the future. The high unemployment we are experiencing now is due to low private investment rather than low government spending. By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment.
The analysis in this Goldman-Sachs report is based on the same type of “large multiplier” theory that predicted that the stimulus package of 2009 would stimulate economic growth. Research by me and my colleague John Cogan finds that more up-to-date theories, which bring important incentive and expectations effects into account, show far smaller multipliers. In these models a reduction in the growth of spending will immediately crowd in private investment. Moreover, by following the stimulus money, we found that in actuality the stimulus package of 2009 had no material positive effect on economic growth or employment. The same economic theory which said the stimulus would increase economic growth in the past two years, says that reversing that spending will reduce growth now. It was wrong in the past and it is highly likely to be wrong again.
There is also the fact that the report confuses budget authority with budget outlays, which is what’s actually spent. Basically, it plugs wrong numbers into an already problematic model.
Unsurprisingly, this morning the Washington Post quoted Mark Zandi of Moody’s making the same claims about the negative impact of cutting spending. Taylor’s criticisms (and mine) apply to his work, too.