Government Spending Affects Gross Domestic Product

In February, the Goldman Sachs economist Alec Phillips predicted that a Republican proposal in the House of Representatives to cut $61 billion from the federal budget in fiscal year 2011 would, if enacted, shave two full percentage points off America’s gross domestic product (GDP) in the second and third quarters of this year. The logic behind this, as with similar analyses by Fed Chairman Ben Bernanke and Moody’s Analytics chief economist Mark Zandi, is that government spending cuts reduce overall demand in the economy, which affects growth and then employment. But this argument ignores the fact that the government has to take its money out of the economy by raising taxes, borrowing from investors or printing dollars. Each of these options can shrink the economy, says Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University.

All these analysts also systematically ignore the fact that GDP numbers include government spending. When the federal government pumps trillions of dollars into the economy, it looks as if GDP is growing. When government cuts spending – even cuts within the most inefficient programs – aggregate GDP shrinks. But that’s misleading.