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Federal finances update




A quick update on Federal finances, which remain in a shambles with a deficit/GDP ratio of about 8.5% (the deficit in the past 12 months was $1.3 trillion). Nevertheless, it bears noting that the growth of spending has moderated significantly in the past two years. The 6-mo. annualized rate of increase in federal spending was 20% in July '09, and that growth rate has declined impressively to only 3.6% as of August '11. It's also very much worth noting that the growth of federal revenues (thanks to an increase in the number of people working, rising incomes, rising capital gains realizations, and very strong corporate profits) has been in the 7-10% annualized range since the beginning of last year. With revenue growth outpacing spending growth, the 12-mo. deficit has dropped from a high of $1.5 trillion early last year to $1.3 trillion.

Thus, if current trends continue, the deficit will continue to shrink. That won't happen, however, unless we reform entitlement programs. And even if we do, the progress will be glacial unless policies coming out of Washington become more pro-growth. The more we can cut the growth of spending and incentivize the private sector to grow, the better off we will be. Rolling back government means expanding the private sector, and the private sector is the only true source of jobs and prosperity.


This next chart shows how important it is to shrink government spending. There's a natural tendency of spending to follow the business cycle, mainly because when the economy slips into a recession, unemployment rises and automatic stabilizers (e.g., unemployment insurance) kick in at the same time that GDP declines, thus giving a big boost to spending relative to GDP. But the past several years have been a fantastic laboratory experiment in what happens when government spending goes into overdrive (e.g., TARP, ARRA, cash for clunkers). The unprecedented post-war increase in federal spending as a % of GDP has coincided with an unprecedented rise in the unemployment rate.

Caveat: it's tough to prove that the rise in spending has been the cause of the rise in unemployment or whether the two are simply being affected by some other variable. But simple logic and everyday experience say that if government spending ramps up enormously, then government is absorbing a significant amount of the economy's resources and using those resources less efficiently than if they had been left in the hands of the private sector. You can't have massive growth of government without the economy taking a hit. Japan, Italy, and Greece are prime examples of economies that have been burdened by excessive levels of government spending and disappointingly slow growth for many years.

UPDATE: The eminent economist John Taylor yesterday presented to the Senate the outlines of a comprehensive, pro-growth budget strategy that brings spending as a % of GDP back to the levels of 2007 (without reducing nominal spending at all), and reforms the tax code in revenue-neutral fashion by broadening the tax base and reducing marginal tax rates. It sure makes sense to me.

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