Politicians, pundits and economists are all forecasting horrific impacts on the U.S. economy as sequestration hits Friday. The basis for this view is the standard — Keynesian — claim that spending cuts slow economic growth, perhaps even causing a recession.
This claim is false.
The Keynesian model of business cycles is taught in most college and high school economics courses around the world. It is accepted wisdom in the halls of government. But its value as a guide for policy depends on a key but under-emphasized assumption.
The Keynesian model does not evaluate government expenditure using the standard microeconomic concept of economic efficiency (cost-benefit analysis). Instead, the model assumes policy should target increased GDP. This sounds reasonable, and consistent with efficiency considerations, until one examines government expenditure in detail.
This expenditure has two components: purchases of goods and services (e.g., roads, education, research, and the military) and transfer payments (e.g., unemployment insurance, welfare, food stamps, Medicaid, Medicare, and Social Security).
Across all categories, federal expenditure is far greater than necessary to achieve the legitimate goals of government intervention.
The efficiency concern with government purchases is that the National Income and Product Accounts value them as equal to the expenditure on these items. This means that bridges-to-nowhere or a military buildup aimed at an imaginary alien invasion are both desirable from the Keynesian perspective because such expenditures increase measured GDP. Yet this expenditure is pure waste.
More broadly, the fact that some government expenditure generates benefits in excess of costs (the economy needs some roads) does not mean additional expenditure generates value in excess of costs (the economy does not need to re-pave its roads every year). At some point additional expenditures hit diminishing returns and make no sense in cost-benefit terms.
Transfer payments are also problematic from an efficiency perspective because they distort economic incentives. Unemployment insurance discourages work effort. Social Security subsidizes early retirement for people who are still able-bodied. Medicare and Medicaid create moral hazard, thereby generating excess health costs. Thus even if transfers help stimulate consumer spending, their net effect on the economy is unclear.
This implies that whether the sequester will harm or help the economy depends on whether cost-benefit considerations can justify the existing level of government expenditure. And on this question, the answer is clear. Across all categories, federal expenditure is far greater than necessary to achieve the legitimate goals of government intervention.
National defense is a classic public good — something that everyone values but that free markets are unlikely to provide — so some expenditure on national defense makes sense. Yet many national security activities have large and certain costs but hard-to-measure and intangible benefits, if any. Examples include the ongoing occupation of Afghanistan, the provision of national security for Western Europe and other parts of the globe, not to mention misguided weapons systems, redundant military bases, and more.
Non-defense, non-entitlement spending is also rife with programs that have no compelling justification and frequently do substantial harm: the National Endowments for the Arts and Humanities, the Corporation for Public Broadcasting, NASA, earmarks, the Post Office, Amtrak, foreign aid, agricultural subsidies, the Small Business Administration, drug prohibition, and more. Even for expenditure that is defensible in moderation (e.g., transportation and education), many specific projects are wasteful (the Big Dig, high-speed rail, No Child Left Behind).
Entitlement spending is also excessive relative to reasonable cost-benefit considerations. A minimal government safety net that provides insurance against the worst-case scenarios for unlucky individuals is one thing; the current generosity of Medicare, Medicaid, and Social Security, which by themselves threaten to bust the entire budget in coming decades, is another. The introduction of higher deductibles, increased eligibility ages, and less generous indexing are all desirable from a cost-benefit perspective and essential if the United States is to avoid a fiscal meltdown.
While the recommendations espoused here may sound heretical, considerable evidence suggests that policymakers should set government spending based on hard-nosed cost-benefit considerations, not Keynesian stimulus concerns.
My colleague Alberto Alesina and his co-authors, for example, have demonstrated that substantial expenditure cuts do not consistently cause output declines, in contradiction to the Keynesian model. Instead, such “fiscal consolidations” result in minor or no short-term output losses and substantial long-term output gains, as the cost-benefit view would suggest.
Thus the main problem with the sequester is that it is too small; it will reduce the deficit only slightly and scale back misguided government only a little.
But it’s a start.