Friday, July 22, 2011

The Slow Growth Panic

Much has been made of the fact that this economic recovery has lost steam as of late. The US monthly jobs reports have not been encouraging, resulting in an unemployment rate that remains persistently high. But a major cause for this slow economy is the fact that, contrary to popular belief, reductions in government spending are a key reason for the growth slowdown.

In 2010, the US federal government's deficit was actually $120 billion lower than it was in 2009. This represents almost 1% of US GDP; therefore, without this headwind, real US GDP growth for 2010 would likely have been higher than 2.9%, which is not enough to meaningfully reduce the unemployment rate. This is because population and productivity growth by themselves can usually be counted on to add 3% or so annually to real GDP, and so only by growing at more than 3% annually will the economy require the help of additional workers.

That trend appears to have continued so far this year. Though real US GDP grew at an annualized rate of just 1.9% in the first quarter of 2011, it did so despite an 8.1% drop in federal government spending and a 4.2% drop in state and local government spending. Since government spending makes up around 20% of GDP, reductions of this nature have a significant effect on GDP.

In other recessions, governments have been able to spend their way out of the economic malaise. For example, the increased spending required by World War II is largely credited with ending the Great Depression. Furthermore, government deficits increased in the three years that followed the recession of 2001, which helped the economy regain its footing.

Today, however, debt levels are high by historical standards. This has reduced the political will to incur further deficits to spend our way out. As such, we should be prepared to incur lower GDP growth numbers for some time. There's no need to panic over this, as it is simply the result of our choice between robust growth and responsible debt management. Once deficits are reduced to what are perceived to be sustainable levels, the drag on the economy will no longer be present and a return to a better growth trajectory can resume.


Chris said...

Consumer balance sheets are wrecked. Households want to pay down debt, so spending is depressed. Meanwhile, business confidence is low. The federal government has done a very poor job of trying to improve business confidence. The poor economy is primarily demand driven in my opinion... The massive cuts to government payrolls won't help this.

Taylor said...

While government spending does compose a large portion of GDP, the government really can't spend money without first taking it out of the private sector. Assuming the government cuts spending and taxes in the same proportion, you may see a GDP decline in the short term but over the course of several years, the private sector would most likely fill the void left by reduced government spending.

reasoninvestor said...

Hey Saj,

Let me first commend you for having the courage to write a post about macro econ. You're bound to get a lot of responses as seemingly everyone has an opinion on the matter (educated and uneducated).

That being said, I believe that the dichotomy between robust growth and high government spending is false. A couple of basic principles are enlightening. To start, the government, by its very nature, deals only in physical force. In fact, that's what a government is- a monopoly on phyiscal force. Because of what it is, government is entirely unfit to do certain things- as evidenced by your local secretary of state office =). Joking aside, force is the opposite of production. Force can help you smash (regulations) and steal (taxation) but not produce. The extent of production is the extent of freedom from force (ie. the space program in communist Russia which was relatively free from physical coercion).

That being said, the government produces nothing. It takes from people who produce and gives it to others. While some 'government jobs' would be real jobs in a private economy, they are stifled at best and a burden on taxpayers at worst.

If government is properly understood, the idea of government fueled growth is absurd. If the government borrows a bunch of money and spends it, the businesses that recieve the money will grow artificially for a short time. This is a fact with which I agree. But what does this cause other then an artificial increase in production and the missallocation of capital as businesses growing from government money recieve private investment? Nevermind the fact that the money has to be paid back somehow!

Unfortunately, Keynesianism (which recognizes consumption, instead of production, as the economic primary) is what is taught in universities and is what most people believe. Spending a bunch of money does not jump start things and only missallocates private capital. If we want robust growth, the government needs to stop spending and get out of the way of the economy.

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