AN OLD SAYING sometimes attributed to Mark Twain goes: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” And so it is with the current view that government spending stimulates the economy. It doesn’t. Government stimulus spending, paid for by running up the federal credit card, is why we have the never-ending Great Recession, though the left keeps fantasizing that spending “saved us from a second great depression.”
Now for the good news: The spending spree is over and Barack Obama is a lame duck. He is legislatively paralyzed. The signature achievement of his first term, the Patient Protection and Affordable Care Act, is under steady fire, and his job approval rating continues to slip. But the best evidence of his shrinking agenda is the trend in federal spending. It’s falling, and not at a trickle. Think Niagara (figure 1).
Washington is experiencing one of the biggest fiscal retrenchments in modern history, and almost no one is paying attention. In the wake of the Bush-Pelosi-Obama spending splurge from 2008-11, federal spending has fallen by 3.1 percentage points of GDP. In the second quarter of 2009, according to National Income Products Account data, federal spending hit 26.5 percent of GDP, thanks to the Obama stimulus and the Bush recession. As of the second quarter of 2013, just as the sequester was beginning to take effect, federal spending as a share of GDP is down to 23.5 percent and, barring some unforeseen emergency, is on track to fall to around 23 percent by the end of this year. The turning point in spending from the binge years of 2009 and 2010 came when the Republicans took control of the House in 2011.
State and local government spending as a share of GDP has also fallen by more than one percentage point over the same period that federal government spending fell by 3.1 percentage points. If Republicans in the House stick to the sequester and future caps already built into current budget law, federal spending will stay at this low level for years to come, and state and local government spending will follow suit.
Not since the economic boom following World War II have we seen such a rapid decline in the federal government’s claim on the nation’s resources. Amazingly, federal spending was $3.92 trillion in 2011 and is now down to $3.80 trillion on an annual basis in the second quarter of this year. This is the first time in 50 years we’ve had two straight years of declining spending.
More good news is that the annual deficit is falling too. The Great Recession, followed by stimulus, bailouts, Cash for Clunkers, unemployment insurance extensions, and other follies raised the deficit to $1.4 trillion in 2009, or just over 10 percent of GDP. By the end of this year, however, the deficit will be closer to $600 billion and 4 percent of GDP. In other words, federal deficits will be 2 percentage points less as a share of GDP than they were three years ago. And the decline may not stop even then.
For liberals who thought that Barack Obama’s second term would mean a 21st-century Great Society spending binge such as we saw from 2009 to 2011, this is a brutal reality. For Keynesians who believe that government spending cuts are “austerity,” this is also miserable news.
By contrast, we believe that this decline in government expenditures is a boon for the economy, and we have the evidence in hand to prove it. But first the big picture: Government spending is taxation, now or later, and cuts in government spending are pro-growth tax cuts. Beyond the essentials of our government—roads, courts, schools, police and fire services, our military—government spending doesn’t create productive resources, especially when it comes on top of the $3.8 trillion a year already spent. The federal government’s main activity now is to redistribute resources, mostly from producers to non-producers. When the money the government takes from workers and producers is used to pay people and companies not to work—food stamps, unemployment benefits, bailouts, Solyndras, Obamacare health subsidies—it’s a double-whammy. Raising taxes on workers and increasing payments to non-workers is why we had the Great Recession and the lousy recovery in the first place.
Many Americans who have sucked up the Keynesian vapors floating around in the ether cannot imagine that government spending actually hurts the economy. But we would love for the government-as-stimulus crowd to explain the chart below of government spending versus unemployment (figure 2). Correlations like this are vanishingly rare. The more the government spends as a share of GDP, the more Americans are out of work as a share of the labor force. Chico Marx’s famous line in Duck Soup puts the Keynesians into perspective: “Well, who you gonna believe, me or your own eyes?”
Moreover, Keynesian stimulus programs have failed in most industrialized nations around the world. After reviewing data for OECD countries both before and during the Great Recession, we found that the bigger the spending stimulus, the slower the recovery. The notion of a Keynesian spending multiplier is too fanciful even for one of Aesop’s Fables.
CRITICS SAY THAT we have it all wrong: They say that government spending goes up because unemployment is high, not the reverse. It is true that when unemployment rises, when the economy slows and hard times begin, government spending on the so-called automatic stabilizers does increase. But far from ameliorating the situation, these programs only deepen and prolong the decline. During the 1970s, the more Congress spent, the higher unemployment rose, and it was not until government spending and taxes were cut in the early 1980s that unemployment went into long-term decline. The same is true for the “Go-go” 1960s, when President Kennedy cut tax rates and government spending, and prosperity returned.
The Keynesians warned that the post-Cold War spending cuts that occurred under President Clinton’s watch would cause economic contraction. Instead we had an employment and tech sector boom to match all booms.
And, as if that weren’t proof enough, in 2009 the Obama economists revved up their economic model to justify spending $830 billion, but subsequent joblessness was about two percentage points higher than they predicted (figure 3). Unemployment was higher in every quarter than they claimed it would have been if we hadn’t spent any of that “stimulus” money at all.
So how did Barack Obama, who promised to be a transformational president—and, one must admit, in his first term, he surely was—manage to corner himself fiscally? During the first three years of the Obama presidency, we saw the biggest budget blowout in decades. Federal spending surged by just over $1 trillion to a post-World War II high of just over 27 percent of GDP in 2010. It looked then as though the $800 billion of stimulus spending would become a permanent addition to agency spending baselines, that the president had succeeded in forever ratcheting up federal expenditures to a new plateau of over one-quarter of all national output.
This didn’t happen in large part because of the creation of the Tea Party movement and the historic 2010 midterm elections, which amounted to an outright repudiation of Obama-Reid-Pelosi spending. The GOP took control of the lower legislative chamber and elevated John Boehner, who is among the unsung heroes in this story, to Speaker of the House. This slammed the brakes on the real spending spree which began in 2007 when Nancy Pelosi took the gavel. In her first two years as Speaker, spending rose by almost $500 billion, and the deficit, which had slid down to $161 billion in 2007, rose to $459 billion in 2008, and then hit the unthinkable height of $1.4 trillion the next year.
THE BIG BUDGET showdown between Obama and Boehner took place during the debt ceiling negotiations of 2011. The president was thought to have been the winner here when Republicans retreated from a debt default stare-down. But as we look back two years later, we see, in fact, that it’s more accurate to say Obama won the short term P.R. battle but lost the war.
Here’s why: House Republicans strongarmed the White House into accepting a series of spending caps that Obama now certainly regrets. First, the White House agreed to the Budget Control Act of 2011 with $1 trillion of deficit reduction over 10 years through expenditure caps. Then the president accepted another $1 trillion of sequesters and lower caps through 2021 after the so-called super-committee failed to reach an agreement on entitlement cuts and taxes. White House budget chief and now Treasury Secretary Jack Lew—the man who came up with the idea of the sequester, according to Bob Woodward’s book on the negotiations—made a catastrophic miscalculation. He believed defense hawk Republicans would never agree to the sequester cuts to the Pentagon. The White House bet that Republicans would raise taxes before cutting military spending.
They were wrong. House Republicans rightly decided that as the wars in Afghanistan and Iraq were winding down, defense would be cut under any scenario. So it made the most strategic sense to uphold the sequester, to ensure that the “peace dividend” did not get spent elsewhere.
No one in their right mind believes the caps will last eight more years or even half that long, which is why we end the analysis in 2015. But for now, the sequester and caps are squeezing not just defense but “investment” programs liberals care most about—everything from the National Endowment for the Arts, to Head Start, green energy subsidies, OSHA and the EPA, foreign aid, public broadcasting, Amtrak, and thousands more. This is a fiscal buzz saw for the army of special interests and unions that depend on government largesse for their survival.
A warning is appropriate here: Any return to a Speaker Pelosi after the 2014 midterm elections would be catastrophic for growth, markets, and fiscal sanity, though the odds of a Democratic takeover of the House are not high. The GOP House is the safety rail against government expansionism, and, should the Democrats take the gavel back in 2014, almost all of the progress noted here would be very quickly reversed.
None of this is to say that Mr. Obama isn’t still inflicting harm on the economy. He is. If it hadn’t been for his insistence on higher tax rates on everything that walks, crawls, swims, flies, or digs, our economy would be soaring. The president’s regulatory assault, which is now estimated to cost about $1.5 trillion a year and includes new heightened efforts to regulate utility and industry carbon emissions, could do severe damage to the efficiency and competitiveness of U.S. businesses. Entitlement programs remain on automatic pilot as they surge full-speed toward the cliff of bankruptcy. The Congressional Budget Office calculates that these programs will grow by almost 50 percent over the next decade. Obamacare alone is scheduled to add more than $1 trillion of new spending over the next decade.
Still, it’s hard to believe that just nine months ago Barack Obama was basking in the afterglow of his re-election victory and promising to continue to lurch the American economy to the socialist left. Republicans will win the budget wars with the White House if they merely defend the spending caps that Barack Obama and Senate Majority Leader Harry Reid have already agreed upon. This creates a status quo that could hardly be more demoralizing for the liberal spending constituencies in Washington, as they see the programs they care most about continue to shrink right before their eyes.
Isn’t it lovely?
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