Does Cutting Government Spending Risk a Recession?

“If government spending is cut too fast, we’ll end up in a recession,” is a popular warning against cutting massive federal spending. But is it true? Will cutting federal spending really sink the economy into a recession? To answer this question, we need careful economic analysis.

To begin, we should define some terms, particularly “recession” and “Gross Domestic Product (GDP).” While there is no singular definition of a recession, the popular definition is two quarters of negative economic growth as measured by GDP. Of course, technical economists add several caveats, but this definition is good enough for our purposes.

GDP is the total summation of spending on final goods and services within a particular geographic location over a particular time period. Economists measure US GDP in quarters and years, and they often compare different countries’ GDPs. While there are several different approaches to measuring GDP, typically GDP is calculated by adding consumer spending (C), business investment (I), and government spending (G) with the value of net exports (NX). In short, GDP = C + I + G + NX. In this formulation, consumer spending (C) accounts for approximately two-thirds of GDP. Thus, whenever consumer confidence wanes, financial markets get nervous. Federal spending (G) accounts for approximately 23 percent of GDP, the next largest category. It is understandable that if a reduction in spending balanced the federal budget, the removal of $2 trillion from total spending would reduce GDP by 7 percent—a deep recession indeed! In comparison, when the US economy was shut down for covid during the second quarter of 2020, GDP fell by 7.5 percent. Thus, there is ample reason to be afraid of a quick balancing of the budget through spending cuts.

However, the story does not end here. Economists are famous for asking people to look at the other side. In this case, the other side consists of what these funds could be doing if the federal government didn’t spend them. One way of looking at the economy is to divide it into the productive private sector and the unproductive public sector. To be clear, the governmental sector of the economy is consumptive, not productive. There are only a few categories that the federal government spends money on. The first is pure consumption, like military spending. The second is transfer payments, where wealth is transferred from taxpayers to others in the form of welfare, healthcare spending, education grants, or subsidies. These forms of spending are not productive. Some might object and point to a third category, like the US Postal Service. While the postal service does create some benefit, it does not cover its costs and is a net loss of wealth to society. In each of these cases, governmental spending is not building or creating new forms of wealth.

Before government can do anything, it must first take resources from somewhere else—the productive private sector. No special insight is needed to see that the private sector is inherently productive. Profits measure the extent to which the private sector transforms natural resources and labor into more valuable goods and services. Losses must either be corrected or such activities cease. Thus, when we examine the extent to which the government adds to the economy, we must first subtract the initial loss of productive private resources. In other words, government spending cannot simply be added to GDP; it should be net government spending. Only the value that is created beyond that of the private sector should be added to GDP. Otherwise, it is a drag on economic growth. The general conclusion is that the government consumes wealth and does not create it.

When the government takes resources from the productive sector and then applies them to unproductive activities, it is clear that this transfer is a net negative for society. Instead of viewing a $2 trillion reduction of government spending through the narrow lens of the GDP statistic, we should see this spending reduction as a freeing up of resources in the unproductive sector for the economy’s productive sector. And the sooner that we make this transfer, the better it will be for everyone.

Will cutting $2 trillion from government spending send the economy into a recession? The answer is no. No doubt there will be a period of adjustment. However, if we allow the market to freely adjust and keep the state and local governments’ noses out of the way, within six months, the economy will be on a solid foundation and ready for major economic growth.

Courtesy of Mises.org

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