Government Spending Affects Gross Domestic Product

In February, the Goldman Sachs economist Alec Phillips predicted that a Republican proposal in the House of Representatives to cut $61 billion from the federal budget in fiscal year 2011 would, if enacted, shave two full percentage points off America's gross domestic product (GDP) in the second and third quarters of this year. The logic behind this, as with similar analyses by Fed Chairman Ben Bernanke and Moody's Analytics chief economist Mark Zandi, is that government spending cuts reduce overall demand in the economy, which affects growth and then employment. But this argument ignores the fact that the government has to take its money out of the economy by raising taxes, borrowing from investors or printing dollars. Each of these options can shrink the economy, says Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University.

All these analysts also systematically ignore the fact that GDP numbers include government spending. When the federal government pumps trillions of dollars into the economy, it looks as if GDP is growing. When government cuts spending – even cuts within the most inefficient programs – aggregate GDP shrinks. But that's misleading.

If Washington spends $1 a year on a bureaucrat's salary, for example, GDP numbers will register growth of exactly $1, whether or not the employee has produced any value for that money.

By contrast, if a firm pays an engineer $1, that $1 only shows up in the GDP if the engineer produces $1 worth of stuff to sell.

This distinction biases GDP numbers – and the policies based on them – toward ever-increasing government spending.

Furthermore, GDP does not capture changes in personal investment portfolios or changes in private research and development spending.

We have tried spending a lot of money to jumpstart the economy, and it has failed. Now we need to cut spending and lift the uncertainty paralysing economic activity. That approach will not just be more fiscally responsible. It will also empower individuals and entrepreneurs, and they are the only ones who can bring on a real recovery, says Rugy.

Source: Veronique de Rugy, Ugly Modeling, Reason Magazine, June 2011.

For text: http://reason.com/archives/2011/05/10/ugly-modeling

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

First published by the National Center for Policy Analysis, United States

FMF Policy Bulletin/ 14 June 2011