The United States is confronting another round of cuts infederal government spending, this time threatening to trim at least 0.5 percentage points fromGDP growth and to precipitatea loss of at least one million jobs. Automatic across-the-board spending cuts, the so-called “sequester,” would reducespending by $85 billion, with defense programs cut by about 8% and domesticprograms by about 5% this year – and with additional cuts of comparable dollar amountsevery year until 2021.
All major government functions – national security, foreignaid, basic research, emergency relief, and education, to name a few salientexamples – would experience an immediate and sizeable funding hit. These cuts,along with the tax increases agreed to in January, would knock about 1.25percentage points off 2013 GDP growth, consigning the economy to another year of tepid recovery anddisappointing job gains.
The real aim of the sequester’s advocates is a smallerfederal government – a goal that often is cloaked in the argument that excessive governmentspending is chokingeconomic growth. Although this is a politically compelling argument, because itstokes public fearsabout an out-of-control deficit, it flies in the face of the facts.
Anemic government spending, not profligacy, has been a major factor behind the economy’s lackluster recovery.According to a recentreport by the Congressional Budget Office, large spending cuts by state andlocal governments – and, more recently, a significant reduction in federalspending – have contributed to the unusual and prolonged weakness of aggregatedemand.
In recent speeches, US Federal Reserve Chairman BenBernanke and Vice Chair JanetYellen have described fiscal policy at the local, state, and federal levelsas a powerful headwindslowing the economy’s return to full employment. In the year after therecession ended, discretionary spending at the federal, state, and local levelsboosted growth at about the same pace as in previous recoveries.
But, since then – and in sharp contrast to previousrecoveries – fiscal policy has become contractionary, reducing aggregate demandand restraining growth. State and local governments have cut spending andpayrolls significantly. And federal purchases of goods and services have beendeclining since 2010, when the temporary additional spending in the 2009stimulus package came to an end.
Even without the sequester, realper capitagovernment spending (including both purchases and transfer payments) hasdeclined under President Barack Obama, while it increased under every precedingpresident since Richard Nixon. (Indeed, per capita spending growth was much fasterunder the Republican administrations of Ronald Reagan and George W. Bush thanit was under Democratic Presidents Jimmy Carter and Bill Clinton.) And, evenwithout the sequester, the federal budget deficit is setto fall at a faster pace during the next two years than in any two-yearperiod since demobilization after World War II.
As a result of a deep and persistent deficiency inaggregate demand, the US economy has been operating far below its potentialoutput level. Real GDP fellby 8% relative to its noninflationary potential in 2008-2009, and hasremained about 8% below its previous growth path ever since.
This translates into about $900 billion of foregone goods andservices this year alone – a tremendous waste reflected in an unemployment rateof 7.9% and a poverty rate of 15%, significantly higher than the average of thepast 30 years. And thewaste accumulates over time: the longer the economy operates far below itscapacity, the slower the growth in its future capacity as a result ofdiminished risk-taking, foregoneinvestment, and erosionof the skills base.
The significant loss of current and future potential outputis all the more remarkable, because it has occurred despite a sustained andunprecedented effort by the Fed to boost demand and hasten the recovery. Fed officials haverepeatedly expressed concern that the prolonged weak recovery will inflict future pain inthe form of slower long-run growth.
Motivated by this concern, the Fed has held the nominalshort-term interest rate near zero – its effective lower bound – for more than five years,with a promise to keep it there until 2015, and has been purchasing about $1trillion of long-term government bonds each year. As a result, the nominal yieldon the ten-year Treasury bond, a widely used measure of the federalgovernment’s borrowing costs, hovers around 2%. That is higher than the record low of 1.4% hitin 2012, but less than half the pre-2008 level and less than a third of its40-year average. In real terms, both short-term and long-term interest ratesremain in negative territory.
Recentresearch has found that the multiplier for discretionary fiscal policy – the change inoutput caused by a change in discretionary government spending – is larger whennominal interest rates are low and there is a significant amount ofunderutilized resources. These conditions describe the US economy as it facesyet another round of government spending cuts that would have negativemultiplier effects on GDP and job growth.
Indeed,these effects are likely to be larger than expected compared to conventionalmultiplier estimates, which rest on two assumptions: the economy is close tofull employment; and the contraction in demand caused by a cut in governmentspending will be offset by a drop in interest rates. Neither assumption appliestoday.
Even worse, the sequester’s across-the-board spending cutsmake no distinction between effective and essential programs and programs thatrepresent special interests or have outlived their original purpose. Such arbitrary cuts are likelyto inflict more damage on the economy than sensibly targeted cuts of the samemagnitude.
The sequester is the product of ideology and political stalemate. It has noeconomic justification. In the long run, additional targeted spending cuts willbe necessary as part of a balanced package to stabilize the debt/GDP ratio. Butthey are not necessary now. Indeed, by endangering the economy’s haltingrecovery, they would be counterproductive.