Spending Cuts and the Economy

Anything the government spends has to be taken from citizens.

Jim Lacey
Wednesday, May 25, 2011

Last week, a number of economics blogs fell all over themselves in a rush to post an article by Kash Mansori. In it, he creates a country called Austerityland, a tiny nation (GDP: $100) that decides to take dramatic action (a $5 cut in government spending) to reduce its budget deficit ($10), and doesn’t get the results it was hoping for. To show us why, Mansori treats us all to an Econ 101 lecture, which unfortunately leaves a few things out.

Mansori trots out one of the fundamental and most revered of economic formulas: GDP = C + I + G + (X − M). Please do not desert me, as this really is important. In this equation, a nation’s GDP equals the total of its consumption (what its people spend), investment (how they use their savings), government spending, and net exports (exports minus imports). Any reduction in any one of these will reduce GDP, thereby reducing the country’s wealth and overall wellbeing.

So, according to Mansori, cutting government spending by $5 causes an automatic $5 fall in Austerityland’s GDP. Worse, because the government is no longer handing out as much money as previously, people will now have less in their pockets for consumption or investment. Thus every dollar in spending cuts takes about $1.50 out of GDP, a phenomenon known as the “multiplier effect.” And it gets even worse: As GDP falls there will be less money for the government to collect in taxes, and revenues will plunge. That, of course, sends Austerityland into a death spiral, as reduced revenues force ever-greater budget cuts, with all the attendant knock-on effects. All told, the $5 cut in government spending brings the deficit down by only about $3 while decreasing GDP by $7.50. For Mansori, anyone failing to see this — he names NRO’s own Douglas Holtz-Eakin as an example — is at best a fool.

Poppycock!

Mansori left out something truly important: Governments have no money. Anything the government spends has to be taken from citizens. (I thought about mentioning businesses as well, but they just pass their tax costs on to the citizenry.) So whenever G increases, the additional money has to come from C and I — that is, out of our pockets. The government may take our money before spending it, or it may borrow the money and take it from us later to pay off the debt — but either way, government spending comes out of C and I eventually. Further, if the government reduces spending, and thus confiscates less money from its citizens, the reverse is true: With more money in their pockets, Austerityland’s citizens will increase both C and I.

This is why the “multiplier effect” does not exist. Harvard economist Robert Barro eviscerated that concept some time ago, showing that every dollar the government spends in fact destroys 20 to 40 cents of wealth.

Still, if the Republicans get their way and dramatically cut spending, there is a major pitfall ahead. Adjustments often take time. For examples of what will probably happen, one only has to look at what took place after our major wars and the ensuing peace. Every large American conflict has seen a dramatic increase in government spending followed by a dramatic spending decrease at war’s end. Unfortunately, the fall is never as dramatic as the increase — wars have a way of putting governments on a permanently higher spending plateau.

In any event, the dramatic reversal in government spending has always led to a sharp post-war recession that takes a few years to reverse. After World War I, it took several years for the Roaring Twenties to get underway. Likewise, after World War II, several years of doldrums passed before the great boom of the Fifties and Sixties. Too many Republicans are neglectful of these examples and are promising that Nirvana will arrive as soon as the government reduces spending. That is not going to happen.

Rather, there is every likelihood that deep cuts in spending will bring about a short but sharp recession as consumers and businesses adjust to the new circumstances. When G is cut, C and I will take up the slack and then some — but it will not happen overnight. If Republican officeholders fail to alert their constituents to the likelihood that large spending cuts will bring about a recession, they risk a backlash that could propel us back toward ruinous deficits. To reduce the chance of such a recession, or at least greatly reduce its length and intensity, any budget cuts must be combined with a pro-growth agenda and hopefully be timed in such a way as to allow C and I to advance rapidly into the gap.

With cash in their pockets, and in full faith and confidence in America’s economic future, Americans will be poised to take part in another great economic expansion. The only thing that can get in the way is folks like Mansori, who continue to insist that the government can spend and invest your money better than you can.