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This chapter is from the book

There's Too Much Government Spending

Let's stop now and take stock of where we are so far in this chapter. We know that two major constraints on America's long-term economic recovery are overconsumption in the consumption driver of the GDP Growth Driver equation and underinvestment in the business investment driver.

The third major constraint on America's long-term economic recovery presents us with a seeming paradox. That constraint is overspending by the federal government.

We saw in Exhibit 1.2 that excess government spending was not a significant constraint on GDP growth throughout much of the nought decade. The problem lay more in structural imbalances in the consumption, business investment, and net exports growth drivers.

This current decade, however, is likely to witness explosive and sustained growth in government expenditures. That such overspending by the federal government might actually slow down America's growth prospects would seem to be a paradox, because according to the GDP Growth Driver equation, if government spending goes up, so must the GDP.

That "stimulus effect" may be true in the short run. However, over the longer term, large and chronic budget deficits represent one of the worst seeds of economic stagnation that any White House and Congress can plant because of their negative impacts on all three other drivers in the GDP growth equation. Before we come to understand why this harm is done, let's take a further look at the deficit and public debt numbers.

Exhibit 1.4 compares the actual budget deficits run in the 2000s to the projected budget deficit picture in the 2010s. In reviewing this exhibit, it is important first to understand that the deficits that occurred during the Bush administration, particularly during the second term of George W. Bush, were historically large in absolute terms. That said, you can see that the Obama deficits projected by the CBO dwarf the Bush deficits.

Exhibit 1.4

Exhibit 1.4 The Daunting Budget Deficits of Our Future

There are several reasons why the Obama deficits are likely to significantly choke growth—and why the CBO estimates that America's real GDP will grow by only 2.4% annually from 2015 to 2020 once the stimulus effects wear off.

The first reason is the simplest to understand. A rapidly rising debt burden for the federal government means that more and more of our tax dollars must be paid to service interest on that debt. With foreigners holding over half of our public debt not held by the Federal Reserve and other government institutions, payments on debt flow right out of America and right out of the GDP Growth Driver equation.

The second problem is slightly more complex. It has to do with how America's budget deficits are actually financed—and whether the financing instrument chosen will be either inflationary or contractionary.

To finance its budget deficits, the American government has two basic options. It can either raise taxes or sell U.S. Treasury bonds. If the Obama administration raises taxes, as it has shown a propensity to do, that will be contractionary for the economy. This is because higher taxes take money out of consumer pocketbooks and thereby reduce consumption in the GDP Growth Driver equation. Higher taxes also take money out of corporate budgets that might otherwise be used to invest in new plants, equipment, and facilities.

Alternatively, if the Obama administration chooses to sell Treasury bonds to finance its deficits, the ultimate effect will be either higher interest rates or higher inflation—depending on who actually buys the bonds.

One possible bond buyer is the general public. In this financing scenario, the Treasury Department sells the bonds on the open market. However, in order to do so, the Treasury Department typically must offer higher interest rates on its bonds as the economy recovers. These higher interest rates, in turn, spill over into the corporate bond market.

In this way, the higher interest rates caused by deficit spending are said to "crowd out" business investment in the GDP Growth Driver equation, thereby slowing down GDP growth.

If the Treasury Department wants to avoid this crowding-out effect, it can sell its bonds to another possible buyer instead—the U.S. Federal Reserve. This type of deficit financing is called Fed "accommodation," and it happens when the Fed is willing to buy the Treasury bonds before they are put on the open market at the prevailing interest rate.

The problem with this type of bond financing and "Fed accommodation" is that it is inflationary. Inflation occurs because the Federal Reserve is simply printing new money to buy the bonds.

Of course, once inflation begins to rise rapidly, the Fed must raise interest rates to control inflation. At this point, you get the same growth-killing, crowding-out effect on business investment as well as on consumer spending for interest-rate-sensitive, big-ticket items such as houses and autos.

The bottom line of this diagnosis is a lesson apparently not understood by the Obama administration. Massive budget deficits are totally incompatible with long-term economic recovery. By definition, they plant some of the most potent seeds of economic destruction of any government policy—higher taxes, higher interest rates, and higher inflation.

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