BERKELEY – The United States is confronting another round of cuts in federal government spending, this time threatening to trim at least 0.5 percentage points from GDP growth and to precipitate a loss of at least one million jobs. Automatic across-the-board spending cuts, the so-called “sequester,” would reduce spending by $85 billion, with defense programs cut by about 8% and domestic programs by about 5% this year – and with additional cuts of comparable dollar amounts every year until 2021.
All major government functions – national security, foreign aid, basic research, emergency relief, and education, to name a few salient examples – would experience an immediate and sizeable funding hit. These cuts, along with the tax increases agreed to in January, would knock about 1.25 percentage points off 2013 GDP growth, consigning the economy to another year of tepid recovery and disappointing job gains.
The real aim of the sequester’s advocates is a smaller federal government – a goal that often is cloaked in the argument that excessive government spending is choking economic growth. Although this is a politically compelling argument, because it stokes public fears about 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 recent report by the Congressional Budget Office, large spending cuts by state and local governments – and, more recently, a significant reduction in federal spending – have contributed to the unusual and prolonged weakness of aggregate demand.
In recent speeches, US Federal Reserve Chairman Ben Bernanke and Vice Chair Janet Yellen have described fiscal policy at the local, state, and federal levels as a powerful headwind slowing the economy’s return to full employment. In the year after the recession ended, discretionary spending at the federal, state, and local levels boosted growth at about the same pace as in previous recoveries.
But, since then – and in sharp contrast to previous recoveries – fiscal policy has become contractionary, reducing aggregate demand and restraining growth. State and local governments have cut spending and payrolls significantly. And federal purchases of goods and services have been declining since 2010, when the temporary additional spending in the 2009 stimulus package came to an end.
Even without the sequester, real per capita government spending (including both purchases and transfer payments) has declined under President Barack Obama, while it increased under every preceding president since Richard Nixon. (Indeed, per capita spending growth was much faster under the Republican administrations of Ronald Reagan and George W. Bush than it was under Democratic Presidents Jimmy Carter and Bill Clinton.) And, even without the sequester, the federal budget deficit is set to fall at a faster pace during the next two years than in any two-year period since demobilization after World War II.
As a result of a deep and persistent deficiency in aggregate demand, the US economy has been operating far below its potential output level. Real GDP fell by 8% relative to its noninflationary potential in 2008-2009, and has remained about 8% below its previous growth path ever since.
This translates into about $900 billion of foregone goods and services this year alone – a tremendous waste reflected in an unemployment rate of 7.9% and a poverty rate of 15%, significantly higher than the average of the past 30 years. And the waste accumulates over time: the longer the economy operates far below its capacity, the slower the growth in its future capacity as a result of diminished risk-taking, foregone investment, and erosion of the skills base.
The significant loss of current and future potential output is all the more remarkable, because it has occurred despite a sustained and unprecedented effort by the Fed to boost demand and hasten the recovery. Fed officials have repeatedly expressed concern that the prolonged weak recovery will inflict future pain in the form of slower long-run growth.
Motivated by this concern, the Fed has held the nominal short-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 $1 trillion of long-term government bonds each year. As a result, the nominal yield on the ten-year Treasury bond, a widely used measure of the federal government’s borrowing costs, hovers around 2%. That is higher than the record low of 1.4% hit in 2012, but less than half the pre-2008 level and less than a third of its 40-year average. In real terms, both short-term and long-term interest rates remain in negative territory.
Recent research has found that the multiplier for discretionary fiscal policy – the change in output caused by a change in discretionary government spending – is larger when nominal interest rates are low and there is a significant amount of underutilized resources. These conditions describe the US economy as it faces yet another round of government spending cuts that would have negative multiplier effects on GDP and job growth.
Indeed, these effects are likely to be larger than expected compared to conventional multiplier estimates, which rest on two assumptions: the economy is close to full employment; and the contraction in demand caused by a cut in government spending will be offset by a drop in interest rates. Neither assumption applies today.
Even worse, the sequester’s across-the-board spending cuts make no distinction between effective and essential programs and programs that represent special interests or have outlived their original purpose. Such arbitrary cuts are likely to inflict more damage on the economy than sensibly targeted cuts of the same magnitude.
The sequester is the product of ideology and political stalemate. It has no economic justification. In the long run, additional targeted spending cuts will be necessary as part of a balanced package to stabilize the debt/GDP ratio. But they are not necessary now. Indeed, by endangering the economy’s halting recovery, they would be counterproductive.