Today’s teachable GDP moment: Slower government spending => slower GDP growth

Today’s GDP report was unexpectedly disappointing, but the economy is likely not entering recession. The downward drag on GDP growth that pushed into negative territory was mostly exerted by changes in private inventories (which are volatile and unlikely to provide a consistent drag on GDP going forward) and a large reduction in defense spending that is also unlikely to be repeated.

The large drag imposed by this defense cutback, however, illustrated the valuable point that fiscal contraction is contractionary: When government spending drops, the economy suffers.  The rest of the economy is simply not growing strong enough to make up for losses in demand due to government spending cuts. And while the defense drag this quarter was extraordinarily large, the trend has been steadily declining public support to the economy for some time now.

The downward trend in government spending can be illustrated by taking a look at current government expenditures, relative to potential gross domestic product. We look at expenditures as a percent of potential GDP because it does not allow a decline in actual GDP (or a slowdown in its growth) to make this ratio look bigger. What we’re looking for is a policy-induced rise (or failure to rise) in the importance of public spending, and expressing this spending as a share of potential GDP better isolates this policy effect. 

Prior to the recession, the federal government spent about 24 percent of potential GDP and state and local governments spent about 12.8 percent of GDP. During the years of peak-ARRA (the Recovery Act) in mid-2010, the federal share rose to 27.8 percent. But as of the last quarter of 2012, federal spending has dropped to 25.9 percent.

As the increase in federal government expenditures after the onset of recession was almost entirely due to explicitly temporary stimulus measures (unemployment insurance extensions, infrastructure spending, SNAP benefit increases, etc.), the winding down of these is totally predictable, and highlights the fact that there has not been any permanent increase in federal spending that has taken effect.1

Today’s GDP report, while overstating the current weakness in the economy, clearly illustrates what economists have known since the 1930s: Government fiscal contraction during periods of excess capacity—particularly when interest rates are already near-zero—is exactly the wrong thing to do. The coming year will see further cuts called for in the Budget Control Act (BCA) as well as possible cuts depending on the resolution of the “sequester” negotiations in March. These cuts will slow economic growth. Maybe not quite as dramatically as this quarter’s numbers indicate, but inevitably.

1.  It is true that there will be a permanent shift up in federal spending associated with health reform (the Affordable Care Act, or ACA), as expanded Medicaid and subsidies to help people afford private coverage take effect. However, it should be noted that in terms of its impact on the federal deficit, the ACA is one of the largest pieces of legislated deficit reduction in history.