As the deficit debate drones on in Washington, there's one essential question that must be answered: would it be better to cut government spending or raise taxes? In order to make deep deficit cuts, Congress must choose one of these options or a combination of the two. Republicans generally support spending cuts. Would they ultimately benefit economic growth? This question is one of the most contentious in the political discourse, but it gets easier to answer if you qualify for timing.
A Washington Post article today says that Republicans think immediate spending cuts will strengthen economic growth immediately. The article says "many" economic analysts disagree. I should hope so, because the claim is trivially false.
The very definition of gross domestic product shows that cutting government spending will cut growth. As you learn in intro macroeconomics, here's how GDP is calculated:
GDP = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (X)
If all other components remain unchanged, then GDP will decline, by definition. That is, unless government spending cuts somehow conjure up growth in the other three components. Could this happen?
How Might Spending Cuts Boost Growth?
Government spending cuts could cause growth only if they increase the other components by more than spending was cut. There's a common argument that this could happen in the long term. Less federal spending allows the government to take in fewer tax dollars. If you believe that the private sector better promotes economic growth than the government, then it makes sense that smaller government paired with lower taxes will lead to higher growth.
But that's not the situation we're talking about here. We're trying to pay down the enormous government debt, so we can't lower taxes in proportion to the spending cuts. Doing so would leave the debt level unchanged. In order for spending cuts in a vacuum to stimulate the economy, they must have some intangible positive effect on one or more of the other components of GDP. Let's think through this.
- Consumption: Less government spending will not provide consumers with more money to spend. So to spend more, they would need to save less or incur more personal debt. These options seem somewhat unlikely, as less government spending probably means the impact of entitlements softens -- so Americans will need to save more, not less.*
- Investment: Less government spending will not provide firms with more money to invest. So they would either need to pay shareholders less or borrow to invest more of their revenue for growth. It's hard to see why cutting government spending would encourage either of these options. At best, you could see the private sector attempt to provide some of the services that government cut, but most of the government's functions tend not to be potential profit centers for firms. More importantly, this would just replace the services the government already provided, so growth would remain flat. Economic activity would remain unchanged: some would just shift from government to firms.
- Net Exports: Less government spending could actually reduce net exports. If the deficit declines, then the dollar should strengthen. While that might sound great, it means that our goods and services will appear more expensive to those overseas. That will make it more difficult to convince them to buy U.S. exports.
You can quibble that government spending shouldn't be a part of the definition of GDP. That position isn't crazy, but it also doesn't change anything. As just shown, those other components will not reflect new economic activity boosting growth if government spending is cut.
Remember, cutting spending takes money out of the economy. That money isn't being replaced. Any further growth will have to occur by draining savings or by taking on more credit. Will less government produce stronger economic sentiment to induce such behavior? It could if the government borrowing was having an adverse negative effect on the economy in some way. Currently, that doesn't appear to be the case. U.S. debt is still being issued relatively cheaply.
The Long-Term Is Another Story
Bear in mind, all of this assumes that we're talking about the short term effects of cutting government spending. There could very well be positive long term effects. Once the debt has been paid down, taxes can be lowered to maintain the level of government spending. Then the private sector can invest more money in the economy and stronger growth can occur. The best solution for deficit cutting would be to develop a long-term plan, with only modest good-faith efforts in the short term to show global investors that the U.S. is serious about fiscal responsibility.
* There is an argument out there that if government cuts spending, consumers will save less because they believe that taxes won't rise in the future. This assumes that they're saving current money to pay for their expected future tax obligation. This is an interesting idea in theory, but I just find it completely implausible that many real, live people behave in this way. I find it more likely that people would react with fear that entitlements are being cut and feel the need to save even more. That isn't necessarily bad, but it does mean that economic growth could be slower, as saving rises and consumption falls.
Update: I just wrote another post responding to the commenters who seem to be enamored with Ricardian equivalence