Tuesday, March 19, 2013

Understanding the House budget plan

John Cogan and John Taylor have an easy-to-understand analysis of the House budget plan that will be voted on this week.

Most importantly, they explain why it is that a reduction in the growth of federal spending can actually stimulate economic activity. Traditional methods of analysis based on flawed Keynesian theories assume that any reduction in spending weakens the economy, and any increase strengthens it. One silver lining to the economic cloud of the past four years is that huge increases in spending (e.g., the ARRA) not only failed to stimulate growth but actually retarded growth. We've just lived through a laboratory experiment in Keynesian economics and found that the theory was dead wrong.

They also explain the importance of incentives, which are missing from Keynesian models, and make the very important point that "the resources to finance government expenditures aren't free—they withdraw resources from the private economy." Since the private economy spends its own money better than the government does, shrinking the size of government—especially when it is as large as it is today—leads directly to a more efficient and stronger economy.

Here's a quick summary of how the House budget plan would help boost economic growth immediately:

First, the lower level of future government spending avoids the necessity of sharply raising taxes. The expectation that tax rates won't need to rise provides incentives for higher investment and employment today.
Second, since the expectation of lower future taxes has the effect of raising people's estimation of future disposable income, consumption increases today. This change comes thanks to Milton Friedman's famous "permanent income" hypothesis that the behavior of consumers reflects what they expect to earn over a long period. According to our macroeconomic model, the higher level of consumption induced by the House budget's effect on consumer expectations is large enough to offset the reduced growth of government spending.
Third, the new budget's reduction in the growth of government spending is gradual. That allows private businesses to adjust efficiently without disruptions.

15 comments:

Gloeschi said...

So just because more government spending didn't lead to higher growth logic demands that lower government spending does? Please. Just look to Europe for the results.

Scott Grannis said...

Europe is pursuing austerity the wrong way: very little in the way of spending cuts, most of the work being done by tax increases. Higher taxes are the thing that is really hurting.

aaron said...

All this might be true but I dont understand why the goal is a balanced budget. We shouldn't run huge deficits indefinitely but I think we are still deleveraging. Cutting taxes as opposed to raising spending might work better, but right now we should probably be doing both.

When we balance the budget no new money gets created. With a growing population and a desire to save some we need to be running deficits to feed the desire to save. A balanced budget equals deflation and then depression if it goes on for too long.

Paul said...

"We've just lived through a laboratory experiment in Keynesian economics and found that the theory was dead wrong."

Right on, but the public will never hear about it. Obama will continue to blame Bush and now the sequester. Paul Krugman thumps his chest regularly about how he was somehow right and everyone who disagreed with him was wrong.

Scott Grannis said...

Re: a balanced budget. I don't see the need for a balanced budget. If the deficit were kept to something like 3% of GDP that might be ideal. The existence of a liquid Treasury market with lots of maturities creates value for markets all over the world. Everything is ultimately benchmarked to Treasuries. The value added by a liquid Treasury market benefits everyone--it's like a public utility. We should keep it from disappearing. But right now the deficit is way too big, and Treasury debt/GDP is also way too big. We've got to get it down, and the best way is to slow the growth in spending (including entitlements) and avoid raising taxes.

RichmondG30 said...

The concept that there are limited resources and that spending by the private sector creates more wealth than does spending by the public sector makes sense. However, it will never be embraced by the Reality TV American Public. The majority of Americans is unwilling or unable to look past the headlines that scream about spending cuts leading to teachers and cops being fired. I think we are in a hopeless situation. Once government spending starts, it is impossible to stop (voluntarily, that is).

Scott Grannis said...

I agree that it seems impossible to stop all these spending programs, but that doesn't mean we have to give up. An idea that makes sense and is the right thing to do will not die. It just needs to be repeated and repeated. Someday I hope another Reagan comes along who can explain these things to the people and trim government. Government is becoming such a huge burden on the productive members of society that I don't think we can continue down the path of more spending for much longer.

Benjamin said...

I agree entirely that federal agency spending, and entitlement spending must be cut.

We spend $1 trillion a year now on defense, homeland security and the VA.

But where are the enemies?

Current defense outlays are double what we spent in 2001 (adjusted for inflation) and more than we spent at the height of the Cold War, when we faced a Soviet Union with thousands of ICBMs, millions in uniform, a blue water navy, a KGB, satellites, supersonic fighters and bombers and more tanks than you can imagine.

Now we spend more, and the "enemy" is a couple oddball states and some guys armed with homemade bombs in Afghanistan.

Dik Armey, Pat Buchanan, Ron Paul, the Cato Institute and a few others have made note of this. We are wasting money on an unnecessary politicized military.

"Liberal " President Obama just keeps spending even more on "defense," and never got us out of the obvious money-losing situation of Afghanistan. In fact, the agreement is not that we leave in 2014, but that we maintain bases and planes there until 2024.

I guess so we can support state-mandated Islam and opium production. Thanks Obama. You have enhanced the Bush Jr. Legacy. And thanks for the $1 trillion or so more we will waste there.







RichmondG30 said...

Benjamin you are exactly right. September 11 was an emotional shock to the American people. They opened their (mostly empty) wallets and said spend whatever you need to keep this from happening again. And thus was born the Department of Homeland Security. For 12 years this ravenous monster has been claiming more and more of our productive resources and diverting them to bureaucrats. What a disaster.

valuelurker said...

Here is a note from a small Govt Conservative who has had it with both parties.

Exhibit A of "conservative" waste. The USA has roughly 4000 M1A1s and M1A2s (tanks) in service with another 4000 in "storage". How many does the Army want, total? 2000.

Its all to "protect" jobs in Lima, Oh. And General Dynamics.

Lukey said...

I read their comments and I generally agree with them (who am I to argue economics with John Taylor?). But I winced a bit when they appeared to be suggesting that the beneficial effects would be immediate. I think it takes a quarter or two before the private sector can get up to speed on such changes and I fear that if the argument isn't made properly that when the economy inevitably slows as the government money gusher is dialed back, if the benefits are oversold, it give the Keynesians the opportunity to point their fingers and say "we told you so." Better to prepare the American people that these solutions take time to take effect (see Ireland for instance) than to set these good policies up for failure by over promising.

William McKibbin said...
This comment has been removed by the author.
William McKibbin said...

After four years of debate, the Congress, President, and public have rejected meaningful government spending cuts -- we need to be discussing what is really going to happen if we are going to make money as investors -- what is going to happen is not austerity (either spending cuts or higher taxes), and not default -- what is going to happen is monetary expansion leading to inflation -- oh, and no debate or public mandate is required to implement monetary expansion leading to inflation -- in the meantime, the US is still trying to stave off deflation -- I'm going to make lots of money in the coming years off of people who are banking on austerity in the face of overwhelming evidence that austerity is untenable politically...

steve said...

RichmondG30 has it exactly correct. On 911 our country irreversibly morphed into a government reliant monster and hasn't changed since-nor will it. the american electorate has been lulled into thinking that more is better and woe be the politician who tries to stop it. we're screwed.

William McKibbin said...

@Steve, the military-industrial Republicans in league with the big government Democrats are the power elite who rule America -- that's reality -- the only question is who is which investors will win in that environment -- any notion of changing the tacit alliance between military-industrial Republicans and big government Democrats is the beginning of delusion leading to failed investment policies -- I always urge investors to see the world the way it is, and then invest accordingly -- hope this is useful for you or others...