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Monday, February 28, 2011

Goldman Sachs Wrong About Impact of House Budget Proposal

Some claim that House budget proposal H.R. 1 to reduce the growth of federal government spending will cause a slowdown in the economy and even increase unemployment. Consider, for example, a recent report by Alec Phillips of Goldman Sachs which claims that the House proposal would reduce economic growth in the second and third quarters of this year by 1.5 to 2 percent if enacted into law next month. Nothing could be more contrary to basic economics, experience and facts. Unfortunately, the report has been widely cited by those wanting to hold back on this first step to restore sound fiscal policy. And the Washington Post reports this morning that Mark Zandi of Moody’s is starting to make similar claims, which should be questioned for the same reasons.

There are several things wrong with the analysis used in Goldman Sachs report. First, it does not take account of the beneficial effects of starting now on a credible plan to reduce the deficit. Basic economic models in which incentives and expectations of future policy matter show that a credible plan to reduce gradually the deficit will increase economic growth and reduce unemployment by removing uncertainty and lowering the chances of large tax increases in the future. The high unemployment we are experiencing now is due to low private investment rather than low government spending. By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment.

The analysis in this Goldman-Sachs report is based on the same type of “large multiplier” theory that predicted that the stimulus package of 2009 would stimulate economic growth. Research by me and my colleague John Cogan finds that more up-to-date theories, which bring important incentive and expectations effects into account, show far smaller multipliers. In these models a reduction in the growth of spending will immediately crowd in private investment. Moreover, by following the stimulus money, we found that in actuality the stimulus package of 2009 had no material positive effect on economic growth or employment. The same economic theory which said the stimulus would increase economic growth in the past two years, says that reversing that spending will reduce growth now. It was wrong in the past and it is highly likely to be wrong again.

The report also confuses budget authority, which is what H.R. 1 is proposing, with budget outlays, which is what is actually spent. Changes in budget authority do not immediately translate into spending; rather such changes gradually impact spending over time. Last Friday the CBO released its analysis of H.R.1 and found that discretionary outlays for 2011 would be $1,356 billion, which is only $19 billion below the CBO baseline of $1,375 billion published on January 26 (Table 3-1). This is less than 1/3 of the $60 billion cut which the Goldman Sachs report assumes in evaluating H.R. 1. Thus the cut in budget authority does not reduce spending “abruptly,” as the report assumes. Rather it is a quite gradual effect. Even if one used the flawed Keynesian multipliers implied by the report, the impact would be less than one-third what the report claims.

In fact, under H.R. 1, total 2011 discretionary outlays would be above 2010 discretionary outlays, which totaled $1,349 billion. And, of course, discretionary outlays are only part of the budget. Total budget outlays will increase by 6.7 percent from 2010 to 2011 under H.R. 1. This is less than the 7.3 percent increase in government spending under the CBO baseline, but it strains credibility to say that the large increase in government spending which still takes place under H.R 1 is too draconian for the economy. Indeed, doing anything less than H.R. 1 should be viewed as a completely non-serious step toward dealing with the debt problem and restoring sound fiscal policy.

As I have written before, the old-style Keynesian approach used by Zandi has many of the same flaws that are found in the Goldman Sachs approach: excessively large multipliers, inaccurate predictions of the effect of the 2009 stimulus, failure to recognize that reducing uncertainty about the debt can have positive effects, especially if it is done in a credible way by reducing spending growth now, not postponing it to a date uncertain in the future. After stating that “too much cutting too soon would be counterproductive,” Zandi claims that this is what the "House Republicans want" and what their budget does. But it's simply not credible to say that a budget that has government spending increasing at 6.7 percent per year cuts spending too much too soon.

In sum, there is no convincing evidence that H.R. 1 will reduce economic growth or total employment. To the contrary, there is more reason to expect that it will increase economic growth and employment as the federal government begins to put its fiscal house in order and encourage job-producing private sector investment.