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Many experts are worried that the impact the Fiscal Cliff – more than $600 billion in tax and spending provisions that will change at the end of the year – could be awful for the U.S. economy.However, government spending has both positive and negative implications, writes Citi economist Steve Wieting.
According to Wieting, historical evidence shows that deficit spending ‘crowds out’ private investment and weakens “productivity, wages and long-term output in the process.”
But tightening fiscal policy always hurts the economy in the short term.
“In the most extreme examples, defence spending dominated growth in the U.S. economy during significant military conflicts. Subsequent withdrawals of defence outlays took the broad economy down with it,” according to Wieting.
Looking at World War II, the Korean War, the Vietnam War, and Persian Gulf war, Wieting offers some key observations on the impact on GDP growth and crowding out of private investment. :1) “Overall real GDP growth was stronger during military conflict phases that included defence build ups than during the two-year periods that followed, in three of four cases during the past seven decades.
The fourth case was unusual in two ways. The so-called (first) Persian Gulf War was a short campaign that took place during an existing short-lived recession. Its impact on defence outlays was also historically small.”
2) “Clear “crowding out” during the conflicts is apparent. The pace of real GDP growth away from defence spending was obviously lower than overall GDP growth in each case. More interestingly, in three of the four cases (or two of three cases excluding the Gulf War), non-defence GDP was stronger in the two years following the conflict than during the conflict period. This is despite the fact that overall real GDP tended to weaken in the years following the conflict as defence spending fell.6
The correlation between Total GDP and non-defence GDP during the conflicts and two-year demobilization periods was -.36. In contrast, over the whole post-world war II period including periods of both war and peace, the correlation between quarterly growth and GDP growth ex defence is +.95.”
World War II and the Korean War both crowded out private investment and WW II in particular shut down an ‘incipient housing recovery from the Great Depression’. During that period, taxes were increased and rationing of consumer goods displaced activity. But U.S. growth and employment were boosted by government spending.
Despite the drop in the U.S. debt-to-GDP ratio in the aftermath of WW II and rise in confidence, overall economic growth was slower after the conflict. And the lack of investment during WWII help drive private demand in the period that followed.