Government Spending and Economic Expansions

by Mike Kimel
Cross posted on the Presimetrics blog.

Government Spending and Economic Expansions

It is conventional wisdom that raising taxes, particularly during and just after a recession, will harm the economy. Last week I checked whether that was true. (The post appeared in the Presimetrics blog and the Angry Bear blog.) The post looked at every recession since 1929, and it showed that recessions that were accompanied by marginal tax rate cuts were followed by shorter, slower expansions than recessions that weren’t accompanied by marginal tax rate cuts. (Expansion, btw, is the term for the period between recessions.)

This week I will look at the effect of cutting back on government spending during and just after a recession. I’m going to do that with three graphs. The first shows the length (in months) of every expansion since 1929. The second looks at the annualized growth in real GDP per capita for each expansion period, and the third looks at the total growth rate in real GDP per capita over the length of the expansion period. In each graph, recoveries are divided into three groups based on what happened to the federal government’s spending as a share of GDP from the start of the recession to the period one year after the end of the recession.

Before I get started, let me describe the data I’m going to use… Data on the starting and ending dates for recessions comes from the NBER, the folks who call the start and end. Real GDP per capita comes from the Bureau of Economic Analysis’ National Income and Product Accounts (“NIPA”) Table 7.1, updated on April of 2010. Real GDP per capita is available annually from 1929 to 1946, and quarterly thereafter. Data on federal government spending comes from NIPA Table 3.2, and GDP figures come from NIPA Table 1.1.5.

As I did last week, I am going to assume that the real GDP per capita in any month is equal to the real GDP per capita for the quarter (or if prior to 1947, the year) in which it fits. In other words, the real GDP per capita (in 2005 dollars) for the first quarter of 2008 is $43,997, and I am assuming that the real GDP per capita in any of the three months in that quarter (i.e., January, February, or March of 2008) is equal to $43,997. Government spending and GDP are treated the same way. That assumption shouldn’t cause any major changes in the results and it will keep me from having to go off on tangents about how the data was smoothed.

With that, here we go. The first graph shows the length of each expansion, in months.

Figure 1

There aren’t a lot of recessions during which spending was cut, but on average, they tended to produce the shortest expansions.

The next figure shows the annualized growth rate during each expansion.

Figure 2

Once again, on average, the recessions during which federal government spending shrunk as a percentage of GDP tended to producer slower economic growth. Two out of the three recessions for which the government cut spending were among the three that produced the slowest economic growth. The third one actually produced rapid growth, but as the first graph showed, that expansion didn’t last all that long either. Which leads us to the third graph, which shows the total increase in real GDP per capita during each expansion.

Figure 3

To summarize – while there were weren’t all that many recessions during which federal government spending as a share of GDP fell, those recessions tended to produce shorter, slower expansions than other recessions. And btw, we get similar results if we use total government spending (i.e., federal, state & local) as opposed to just federal government spending.

Now… consider last week’s post, which showed that recessions during which marginal tax rates were followed by underperforming expansions. The two findings seem to suggest that when it comes to getting the economy moving again during and just after a recession, government spending seems to be more important than private sector spending. One reason this might true – during recessions most private sector players companies hunker down and cut spending, and they usually don’t start investing and hiring people until they’re reasonably sure there’s going to be demand for their products and services. Meanwhile, individuals cut back too, fearful they might lose their jobs.

With everyone waiting until the other guy moves first, there isn’t much of a foundation set down for future growth. But if the government steps in and acts when nobody else is willing to do so, it could create that more stable environment the private sector needs in order to get off the ground.