Declining Government Spending Has Been A Huge Drag On The Recovery

This post originally appeared at The Economist.

PAUL KRUGMAN has been hammering home the point that government spending and employment trends have been highly anomalous during the present American recovery (see thisthis, this, this, and this).

Real federal government spending has mostly tracked that in a typical recovery.

State and local government spending have plummeted in recovery, however, where normally they rise strongly.

You can see the net effect in the table below, from a recent paper by Michael Feroli, Ethan Harris, Amir Sufi, and Kenneth West:


Government spending grew by 5.7% on average during the 10 quarters after the recessions of 1975 and 1982. This time, there was a decline of 2.7%.

I’m not going to suggest that this was a good thing. If one assumes that a structural fiscal adjustment was necessary, it still seems very unwise to crowd that adjustment into the two years immediately after a deep recession. There was no good reason for allowing the fiscal contraction America experienced at the state and local level, where highly procyclical budgeting is often necessitated by law. Better policy would have, at a minimum, provided more cushion to state and local governments and less of a government contraction overall.

It’s worth being a little careful when drawing lessons from all of this, however. If you look at the table above, you see that the housing sector was responsible for more of the drag relative to other recoveries than was government. And as the authors explicitly note, government spending and local government spending especially, given its dependence on property tax revenue is a housing-sensitive sector. Government cuts impaired recovery, but they should also be understood as a symptom of the much more significant impact of the collapse in housing and consumption generally. Similarly, the greater contribution from government during the Reagan era was less a driver of that recovery than a reaction to the extraordinary recovery in housing driven by tumbling interest rates.

The fiscal side matters. It is also a symptom of failure particularly at the central bank to respond adequately to the downturn. The paper from which the table above is drawn essentially argues that monetary policy was too weak through this business cycle because the housing transmission channel was clogged. Fine. The correct response to the problem is to push harder, such that other channels can contribute more and pick up the slack. We shouldn’t allow the spending story to exculpate the Fed.

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