Ripping the Guts out of Recovery

The U.S. has a temporary reprieve on the debt ceiling limit – tax revenues have come in higher than expected in the early part of the year, reducing the needed pace of borrowing by the U.S. government. While this has pushed the deadline for Congressional action back by a month or more, the rhetoric in Washington continues to be intense. As quick background…Congress periodically authorizes  new limits to borrowing to cover new debt. Public radio’s Planet Money has a good, short description of the ceiling. That ceiling needs to be adjusted upwards by Congress in order for the Treasury Department to sell more U.S. bonds (i.e. borrow more).

Credit Greg Uchrin
Credit Greg Uchrin

The coming vote on raising the debt ceiling is giving the Republicans a chance to push for a less-government/less-spending program. Speaker Boehner issued a challenge earlier this week, as reported in The New York Times,

‘Without significant spending cuts and changes to the way we spend the American people’s money, there will be no debt limit increase,’ Mr. Boehner told members of New York’s business and finance community. ‘And cuts should be greater than the accompanying increase in debt authority the president is given.’ Mr. Boehner said those cuts should be in the trillions of dollars, not billions.

So, what would happen if trillions, or even just $100 – $300 billion was cut from Federal spending? University of Oregon economics professor, Mark Thoma, was asked this question and wrote about it in MoneyWatch.

Thoma’s bottom line is

Even a much smaller cut, say $100 billion over the next year, would still wipe out 500,00 jobs over that time period — 2 months of job creation at present rates — and set the recovery back considerably.

For students in macroeconomics there are some good reminders of basic economic forces. I recommend reading the MoneyWatch posting. Look for these important uses of macroeconomic theory:

  • The multiplier (AKA the Keynesian Multiplier). When the government spends money, that initial increase in spending adds directly to GDP. Government spending is one of the four main elements of GDP, along with Consumption, Investment, and Net Exports. Then, depending on how that money is used (spent vs. saved) those funds cascade through the economy, prompting more spending (usually personal consumption). That means the original government expenditure has an impact on GDP that is a multiple of the original amount. In theory that multiplier could be as high as 5, but applied research suggests figures between 1 and 2. Thoma makes a point that was new to me, that the multiplier can be different depending on the state of the economy – lower when the economy is closer to full employment, and higher during recessionary times. (Note to self – look this up.)
  • Okun’s Law. Okun saw a relationship between changes in GDP and changes in unemployment. He observed empirically that a two percent drop in GDP was associated with a one percent rise in unemployment.

Putting it all together – Thoma estimates that a $600 billion drop in government spending over two years ($300 b in one year) will reduce GDP by two percentage points and raise unemployment by 1 percent. That is about 3 million workers losing their jobs. That would rip the guts out of our recovery.

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