WHAT ARE THE CONSEQUENCES OF FEDERAL BUDGET DECREASES

A key metric in how well our (U.S.) economy is doing is GDP (Gross Domestic Product). The formula for GDP is:

GDP = C + I + G + Net Exports , where C is consumption, I is investment, G is government spending, and Net Exports is total exports - total imports.

To get a positive GDP, Net Exports has always been negative since 1977 because of our insistence on importing so much oil so C+I+G must increase to make up for the Net Exports. The sum of these three almost always will more than make up for the negative Net Exports although the trade deficit can be significant ($695.9 billion in 2007*). Now there is a move to try to eliminate or at least reduce Government deficits or reduce G (i.e. government spending in the formula). Therefore, C+I must increase more than the reduction in G plus a negative Net Exports in order to achieve a positive GDP. The bigger the reduction in G, the more difficult it will be for C+I to turn GDP positive.

Recently congress passed and the president signed a bill to cut the 2011 Federal budget by $38.5 billion in the last five months of the fiscal year.** If all these budget cuts were to occur this fiscal year as many wanted, to have a positive GDP over this period means that C and I must increase by more than $38.5 billion during these five months. I confess I have no idea how easy it would be for C+I to do this; however, consumption under the present depressed economic environment, where median household income is declining, is unlikely to increase much. So it falls mainly on investment to increase by most of the $38.5 billion.

It turns out, however, that only about $385 million of the $38.5 billion will occur in Fiscal Year 2011, and I would expect the economy to easily handle that. But the rest of the cuts are real though they will occur in future years and spreading them out like that should make them easier to handle especially if the economy continues to recover from the Great Recession.

There will be attempts to make even larger cuts in the Federal budget in future years so the impacts on GDP will be larger if they are instituted. Actually, the best time to cut the Federal budget significantly is during a rapidly rising economy when both C and I are rapidly increasing and not, as now, during a slow recovery from a Great Recession. Yes, declining G will lower the GDP by some amount during a rapidly expanding economy depending on the size of the Federal budget reduction and on how fast C+I are increasing.

I suspect that most people who want large budget cuts NOW (including nearly all "tea partiers" it would seem), do not understand the equation for GDP. There are those, however, that do (e.g. John Mauldin). With them, they feel that cutting the Federal budget will give a morale boost and help the economy. More specifically the expectation is that Federal borrowing drives out private sector borrowing because there is only so much money. This claim is faulty, however, in that no one forces industry to buy Treasury bonds, notes or bills. If they are doing it, it is because the don't know of anything better to do with the money and want to park it somewhere safe. In addition, the wealthy do not invest much of their money on productive things in America but put a lot of it voluntarily into government bonds (not all American Treasuries) and "... goes to things that may benefit the global economy but have no or little benefit to the U.S. - such as purchasing chalets in Switzerland, Canadian bombardier personal jets, islands in the Bahamas, and the like.*** As the amount of Treasuries are reduced, the wealthy will probably still buy them in their usual amounts because they want to put most of their money into safe securities rather than taking on more risk, though this may drive up the price of the bonds.

The point is that if reductions in the Federal budget are instituted too rapidly, investment and consumption may not be able to keep up and therefore plunge our GDP into negative numbers, thus creating a recession or worse. Our best hope is that the current economic recovery continues and even accelerates which would even make the size of the Federal budget reductions more manageable. After all, Federal revenues are the lowest they have been in 60 years.

* http://en.wikipedia.org/wiki/Economy_of_the_United_States

** http://stopcontinentaldrift.blogspot.com/2011/04/385-billion-is-lot-of-money.html

*** http://stopcontinentaldrift.blogspot.com/2010/05/effectiveness-of-taxes.html

DOES GOVERNMENT SPENDING HAVE A MULTIPLIER?

I keep hearing that government spending has no multiplier effect on the economy, and I have wondered what is behind this so I started Googling around and found the following article from the Heritage Foundation (URL at the bottom). I guess my thought is that the reasoning is partially correct and partially wrong. First I'll start with what I think is at least mostly wrong:

And if the original $1.2 trillion in deficit spending failed to slow the economy's slide, there was no reason to believe that adding $200 billion more in 2009 deficit spending from the stimulus bill would suddenly do the trick. Proponents of yet another stimulus should answer the following questions: (1) If nearly $1.4 trillion budget deficits are not enough stimulus, how much is enough? (2) If Keynesian stimulus repeatedly fails, why still rely on the theory?

The problem with this paragraph is that the $1.2 trillion dollar deficit was not from NEW spending by the government,it was almost entirely because of a decrease in revenues by the government from decrease income and production due to the great recession. In other words, the government kept performing its old programs while the money to implement them decreased. After all, you would have to eliminate the ENTIRE Federal government as we know it (including the DoD) to eliminate the estimated deficit this year. The following paragraph, however, makes some sense:

Congress cannot create new purchasing power out of thin air. If it funds new spending with taxes, it is simply redistributing existing purchasing power (while decreasing incentives to produce income and output). If Congress instead borrows the money from domestic investors, those investors will have that much less to invest or to spend in the private economy. If they borrow the money from foreigners, the balance of payments will adjust by equally raising net imports, leaving total demand and output unchanged. Every dollar Congress spends must first come from somewhere else. This paragraph would be true if the wealthy, for example, spent the money comparable to what the government does. In other words, if the wealthy increased the number of homes they were building, say, to counteract an increase of government infrastructure spending (most on roads, so far, I believe). Thus a billion dollars spent on new houses by the private sector would probably have a multiplier equivalent to a billion dollars spent by the government on roads. Would that reality be this way. I've explained why it would not more than once on this blog. For a long version: http://stopcontinentaldrift.blogspot.com/2010/05/effectiveness-of-taxes.html.

In brief, much of the wealth of the wealthy is not invested in productive things for this country, and the sums invested in productive things does not increase significantly in a recession. It is not just I who have this reasoning, but Greenspan too worried that too much of the gain from the Bush tax cuts would be invested in bonds by the wealthy and the middle class in paying off debt. Suppose the wealthy increased their purchases of real estate in a recession when it can be purchased at fire sale prices? To what degree would this stimulate the economy. So far as I can tell it would be none or at least very little. After all, the amount of real estate in the country is constant. But I do agree that much of the stimulus money spent so far has been defensive, i.e. spent on preserving existing jobs of teachers, policemen, firemen, etc., and, therefore, preserved jobs rather than create new ones. But if this was not done, there would be considerable purchasing power lost to the economy. Would the wealthy have picked up not only the slack, but increased their spending on productive things? I sincerely doubt it. Thus I think the government spending does have a multiplier, more like Zandi's analysis: Mark Zandi of Economy.com has boiled down the government's influence on America's broad and diverse $14 trillion economy into a simple menu of stimulus policy options, whereby Congress can decide how much economic growth it wants and then pull the appropriate levers. Zandi asserts that for each dollar of new government spending: temporary food stamps adds $1.73 to the economy, extended unemployment benefits adds $1.63, increased infrastructure spending adds $1.59, and aid to state and local governments adds $1.38.[4] Jointly, these figures imply that, in a recession, a typical dollar in new deficit spending expands the economy by roughly $1.50. Others, I am sure feel differently.

http://www.heritage.org/Research/Reports/2010/01/Why-Government-Spending-Does-Not-Stimulate-Economic-Growth-Answering-the-Critics

Slightly modified from Investment Analysis Clubs/Macroeconomic Trends and Risks of Motley Fool