Sequester Budget Cuts Would Increase Long-Term Economic Growth

by Hans Bader on February 12, 2013 · 1 comment

in Deregulate to Stimulate, Economy, Employment, Labor, Legal, Regulation, Stimulus to Nowhere

The automatic budget cuts contained in the sequester will increase economic growth in the long-term, if Congress will just let them happen—rather than listening to Obama’s pleas to cancel the cuts, which are currently scheduled for March.  As I note in today’s National Post, in response to a column by David Frum:

David Frum claims modest automatic budget cuts scheduled to go into effect in the U.S.A. in March will somehow harm the economy if they aren’t cancelled. But those cuts are tiny compared to Canada’s budget cuts in the 1990s, which fueled economic growth. The cuts are just 0.5% of U.S. GDP. While the Congressional Budget Office says the cuts will reduce growth in the short run, it says they will increase economic growth in the long run by cutting debt burdens. Mr. Frum wrongly blames a U.S. recession in 1937 on budget cuts. What really harmed the U.S. economy then were bad economic policies such as an undistributed profits tax that discouraged investment, and a 1937 Supreme Court decision that unexpectedly upheld a costly labour law that lower courts had struck down. That court ruling led to a wave of strikes that shrank industrial output.

As I noted in the August 5, 2011 New York Times:

In 1937, the Supreme Court upheld anti-business legislation that had been struck down by lower courts, like the National Labor Relations Act, in decisions like National Labor Relations Board v. Jones & Laughlin Steel Corporation. That made unions more powerful, led to a wave of costly strikes and discouraged hiring. The increased wages demanded by unions resulted in employers’ laying off many workers.

Economists have identified several other factors that they believe led to the 1937-1938 Roosevelt Recession. Those include, but were not limited to, (1) increased reserve requirements for banks, which limited the availability of credit needed by businesses to expand;  (2) tax increases in general; and (3) an undistributed profits tax that encouraged companies to pay out hefty dividends before it went into effect, while reducing investment and productive capital thereafter, artificially pumping up the economy in 1936 and then depressing it beginning in 1937. The harmful undistributed profits tax was reduced in 1938, and then completely eliminated in 1939, after voters removed dozens of liberal Congressmen from office in the 1938 elections. The 1938 mid-term election resulted in so many liberal Democrats losing their re-election races that a coalition of Republicans and conservative Democrats was able to block additional anti-business measures from being enacted, resulting in the restoration of business confidence and economic growth. (My college economics textbook blamed the 1937-38 recession largely on increased bank reserve requirements, although it probably exaggerated their effect, since some banks had spare reserves, and the volume of bank lending did not fall that much, although bank purchases of commercial paper did fall more).

It is not true that the recent economic slow-down in the last three months of 2012 was caused by reduced government spending, as I explained here in The Washington Examiner and John Berlau noted here at this link.  The economy grew by a fraction of a percentage point in that quarter, due to expanding energy production; initial news reports claimed that the economy had shrunk by 0.1 percent.

Government spending increases under Herbert Hoover did not prevent the Great Depression from deepening, nor did large budget cuts in 1946 harm the long-term growth of the U.S. economy.  Increased government spending generally crowds out private investment and harms the economy.

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