GDP Revision and Government Spending

Posted by Jeff Carter
on February 25th, 2011

Bloomberg reports that the GDP revision this morning, from 3.2% down to 2.8%, and infers the drop had a lot to do with reduced government spending. The revised figure is close to the Fed target rate of 3-3.5% GDP provided inflation is at around 1-1.5%.

Their article assumes that government spending is a big driver of GDP. That sort of thinking is incorrect, and relies on Keynesian economic theory. If government spending can drive GDP higher, then we should spend more and recessions would be avoided.

I think people get a couple of things confused. First, government spending as a percentage of GDP has risen over time. Here is a chart since 1950, along with projections out to 2015. In World War Two, we had record levels of government spending relative to GDP, but that is because we were trying to save the entire free world. The Iraq/Afghanistan War is really an insignificant amount of spending relative to GDP. The real killer is entitlements.

This chart is a good graphic of the different types of government spending.

So what drives GDP growth? The answer is simply the private sector. In the classical model, the consumption function is paramount. Milton Friedman wrote a paper outlining the model in 1957, and then he and other economists continued to develop it. Government spending as an input is around 10% of the output resulting in GDP figures. GDP is driven by investment by the private sector, and consumer spending.

This is why there is such a terrific debate over how the government taxes, and spends money. Because at any given time in the economy there is a fixed supply of money, excessive government spending crowds out private investment. This is a drag on GDP. Higher taxes also leave less cash available for investment, and also alter behavior, dragging down GDP.

Currently, Keynesian economists, like Paul Krugman and Austan Goolsbey, are out there fanning the flames of fear, stating that a decrease in government spending will damage the economy. However, from practice we know this not to be true. Otherwise the huge stimulus passed by Democrats in March of 2009 would have put us on the road to economic prosperity. Instead, it retarded growth and left legacy costs that are an overhang on the economy.

We have tangible proof that cutting government spending and lowering taxes works. All one has to do is look at wealth and GDP growth from 1982-2000. Macroeconomics is an inexact science for predicting the future for sure, but it’s not rocket science. The solution is pretty simple, drastically slash government spending and lower tax rates. GDP and private incomes will begin growing again.

The Republican objective of going back to 2008 spending levels is but a drop in the bucket to what they really could do. Government interferes in just about every industry in America. If we look at our nation’s oil policy, agricultural policy, telecommunication policy, and labor policy, the heavy hand of government is slapping business around via taxes, regulation or laws. The Republicans have made a tepid change. Both parties need to come together to make significant changes to avoid the coming train wreck that awaits us a few years down the track.

The net present value tables never lie if you use them correctly.

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