Our good friend Larry Kudlow wrote today in his blog:
"Even with the fourth-quarter contraction, the latest GDP report shows that falling government spending can coexist with rising private economic activity. This is an important point in terms of the upcoming spending sequester. Lower federal spending, limited government, and a smaller spending-to-GDP ratio will be good for growth.... by keeping resources in private hands, rather than transferring them to the inefficient government sector, the spending sequester is actually pro-growth."
We completely agree. Overall GDP contracted by 0.1% in the fourth quarter, but consumption, business investment and housing combined (what we will call the private economy) grew 3.4% at an annualized rate. We don't think one caused the other directly, but government spending itself does not drive the economy.
A perfect test tube example was World War II. Remember, GDP = C + I + G + X - M, consumption plus investment plus government spending plus exports minus exports. So, in the 1940's, GDP soared because of war-related government spending. Nonetheless, the private economy stagnated. After the war, when government spending fell back, the private economy soared.
In the chart above, the blue line is total GDP; and the green line is the private economy (personal consumption plus business investment). The red bars are government spending. GDP rocketed upward from 1941-1945 as government spending surged. Private spending fell initially, then recovered, but was basically flat for the period as a whole. In other words, despite the fact that government spending boosted GDP, private spending and living standards did not improve.
In 1946, the war was over and government spending plummeted. This pulled down overall GDP, but the private sector boomed as the US was launched into one of its greatest periods of growth ever.
Government must be funded by either borrowing or taxation. Both take resources from the private sector. In other words, the bigger the government is, the smaller the private sector is. If government spending could actually create wealth, then there would not be one impoverished person in the entire world – it would be too easy to fix. But government spending does not create economic growth. If anything, more government spending (once government gets past a certain size) hurts the economy.
This may not be apparent at first because our statistics include government as part of GDP, but a look at the underlying data shows the story clearly. Less government means higher standards of living.
As a result, we do not look on the slight 0.1% contraction in real GDP growth during the fourth quarter of 2012 as a negative sign for job growth, consumption or wealth creation. In fact, a decline in government spending is helpful to economic growth. Let's allow the sequester to happen. It will be good for the economy.
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