Why the Economy Needs Spending, Not Tax Cuts

On Friday, Mort Zuckerman, owner of the New York Daily News, exercised his prerogative by publishing an essay in that publication complaining that “Obama’s spending and borrowing leaves U.S. gasping for air.”

This is common criticism among Republicans, who have a vested interest in blaming everything bad that happens on the Democrats. The implication is that if voters weren’t so stupid and had instead elected John McCain to be president then the budget would be balanced, the debt would have disappeared, and the economy would be booming.

Mr. Zuckerman, however, is generally thought to be a liberal Democrat. And as a newspaper owner he likes to pretend that he is a journalist. But he or whoever ghosted this op-ed for him neglected to check the facts.

According to the Congressional Budget Office’s January 2009 estimate for fiscal year 2009, outlays were projected to be $3,543 billion and revenues were projected to be $2,357 billion, leaving a deficit of $1,186 billion. Keep in mind that these estimates were made before Obama took office, based on existing law and policy, and did not take into account any actions that Obama might implement.

Therefore, unless one thinks that McCain would have somehow or other raised taxes and cut spending (with a Democratic Congress), rather than enacting a stimulus of his own, then a deficit of $1.2 trillion was baked in the cake the day Obama took office. Any suggestion that McCain would have brought in a lower deficit is simply fanciful.

Now let’s fast forward to the end of fiscal year 2009, which ended on September 30. According to CBO, it ended with spending at $3,515 billion and revenues of $2,106 billion for a deficit of $1,409 billion.

To recap, the deficit came in $223 billion higher than projected, but spending was $28 billion and revenues were $251 billion less than expected. Thus we can conclude that more than 100 percent of the increase in the deficit since January is accounted for by lower revenues. Not one penny is due to higher spending.

It should be further noted that revenues are lower to a large extent because of tax cuts included in the February stimulus. According to the Joint Committee on Taxation, these tax cuts reduced revenues in FY2009 by $98 billion over what would otherwise have been the case. This is important because the Republican position has consistently been that tax cuts and only tax cuts are an appropriate response to the economic crisis.

According to the Council of Economic Advisers, as of August the actual budgetary effect of the February stimulus was to reduce revenues by $62.6 billion and raise spending by $88.8 billion. Of the spending, the vast bulk went to transfers such as extended unemployment benefits and aid to state and local governments, which may have prevented cuts in spending that would otherwise have occurred but probably didn’t do anything to increase spending. Only $16.5 billion in stimulus funds went to investment outlays for things such as public works. This is a trivial amount of money in a $14 trillion economy.

As if we needed further evidence that transfers have virtually no stimulative effect, the Bureau of Labor Statistics just issued a report on the 2008 tax rebate showing that only 30 percent of the money was spent; the rest was saved, thus providing no stimulus to short-run growth. (See also this CBO report and this new working paper from the National Bureau of Economic Research confirming this analysis.) On January 24, 2008, George W. Bush assured the country that a tax rebate was just the right medicine to prevent an economic downturn.

It continues to amaze me that no one on the left or right seems to have noticed that the essential factor causing the economic downturn is a decline in velocity: the number of times that money turns over in the economy, which is measured as the ratio of the money supply to GDP. In 2006 and 2007 this ratio was 1.9. I take that as normal. In 2008, velocity fell to 1.76 and currently is 1.69. (I divided end of year M2 into 4th quarter GDP; the latest figure is 2nd quarter GDP divided by end of June money supply.)

If velocity were 1.9 instead of 1.69, 2nd quarter GDP would have been $1.6 trillion higher. Therefore, no recession. The output gap would have simply disappeared. From this I conclude that a lack of spending in the economy is the central problem and the only policies that will help are those that increase spending – consumer spending, investment spending, net exports or government spending. How tax cuts would have helped – or at least the type of tax cuts advocated by Republicans – is a mystery to me.

I continue to believe that the Republican position is nonsensical. Final proof is that the previously cited CBO report shows total federal revenues coming in at 14.9 percent of the gross domestic product in FY2009. According to the Office of Management and Budget, one has to go back to 1950 to find a year when federal revenues were lower as a share of GDP. For reference, revenues averaged 18 percent of GDP during the Reagan administration and were never lower than 17.3 percent – 2.4 percent of GDP above where they are now.

I think there are grounds on which to criticize the Obama administration’s anti-recession actions. But spending too much is not one of them. Indeed, based on this analysis, it is pretty obvious that spending – real spending on things like public works – has been grossly inadequate. The idea that Reagan-style tax cuts would have done anything is just nuts.

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