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Sequestration Will Slow Real GDP Growth - But Not Because of Demand-Side Effects

By: Paul Kasriel | Tuesday, February 19, 2013

In my February 5, 2013 commentary "2013 Economic Outlook - Bright Sunshine for the U.S., Some Cloud Abroad," I argued that changes in federal fiscal policy have no material impact on total spending on the economy, but rather affect the distribution or composition of a given amount of total spending. The crux of my argument was that other private spending would "crowd in/out" changes in demand emanating from changes in tax and/or government spending policies. In this commentary, I will amend that argument. A change in government spending will affect total real spending in the economy to the extent that this government spending represents a good or service that enhances commerce and is not being provided by the private sector. That is, to the degree that a government-supplied good or service affects the economy's potential to produce goods and services, changes in the provision of these government-supplied goods and services will affect the economy's real output. In these cases, changes in government spending will affect real economic growth from the supply side, not, as mainstream economists would have you believe, from the demand side. Some of the cuts in federal spending that are scheduled to take effect on March 1 in connection with sequestration fall into this category of affecting the supply side of the economy.

Before the adoption of satellite navigation systems, lighthouses played an important role in enhancing marine shipping and travel. Without lighthouses, there would have been more ships foundering on coasts, which would have depressed real output. So, if there had been a sequestration a century ago that necessitated the closure of some lighthouses, U.S. commerce and, thus, real output, would have suffered. Similarly, if sequestration occurs on March 1, our air transportation system will be adversely affected primarily by the reduction in air traffic controllers and secondarily by the reduction in TSA agents. Fewer air traffic controllers imply a reduction in flights, both passenger and freight. Fewer air traffic controllers imply longer tarmac delays for the flights that actually do occur. Fewer TSA agents would likely imply longer wait times in airport security lines. This reduction in air transportation will slow the wheels of commerce, i.e., slow real GDP growth. Creating more "thin-air" credit on the part of the Federal Reserve will increase the demand for goods and services, including the demand for air transportation, but increased "thin-air" credit will do nothing to increase the supply of air transportation and real GDP growth. Rather, an increase in "thin-air" credit in the face of a reduced ability for the economy to grow in real terms will lead to higher inflation.

Sequestration will reduce the number of federal food inspectors. This will reduce the availability of certain food products at grocery stores and restaurants. Again, real GDP growth will slow because of supply-side factors, not because of reduced demand.

Sequestration obviously would cut federal government spending on many other programs than just air traffic control and food inspection. Head Start programs will be cut. Pre-natal nutrition programs will be cut. And the list goes on. Although the services provided by these programs might affect the economy's potential to produce real goods and services 15 or 20 years from now, it is doubtful that the reduction in these programs would have an immediate negative supply-side effect on the economy. Rather, these and many other programs tend to merely redistribute a given amount of aggregate spending demand in the near term. Thus, reductions in federal government spending on these types of programs unlikely would have a negative affect total spending in the economy after a quarter or two. Private sector spending would likely "crowd in" the spending vacuum left by the reduction in government spending. So, by simplistically subtracting the amount of federal spending being cut on these programs from GDP to get a forecast of the negative impact of sequestration on GDP growth is wrong and exaggerated.

In sum, if sequestration does occur on March 1 and persists for several quarters, real GDP growth will be adversely affected. But the reason for the adverse effect on real GDP is much different than what mainstream economists are arguing. And because the reason is different, the estimates being provided by mainstream economists on the adverse effect of sequestration on GDP growth are incorrect and exaggerated.

 

Author: Paul Kasriel

Paul L. Kasriel
Econtrarian, LLC

Paul Kasriel

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

Copyright © 2013 Paul Kasriel