Potential cuts in Federal spending scheduled for January as part of the so called fiscal cliff should not hamper growth next year. The relationship between Federal spending and growth has been substantially different in the last 30 years than it was during the time John Maynard Keynes developed his theories about government being able to stimulate aggregate demand with increased spending or lower taxes. The current relationship suggests there is no danger that cutting spending next year will harm growth next year. There are likely other reasons to expect economic weakness next year, but not from spending cuts.
The cause of something is the sum total of everything that has happened in the past or present. Making a prediction comes down to trying to understand the context. Often something that influences a situation one way will influence it in the exact opposite way under a different set of circumstances. A significant part of the context of how changes in Federal spending affect growth may be the national debt. The period I am examining began in the fourth quarter of 1981 when debt measured in real per-capita dollars began a dramatic increase. Debt measured this way, as shown in the red line on the chart, was roughly flat from the 1960s into September 1981.
From the 1920s into the 1950s growth in Federal spending and GDP went up and down together with little or no lead or lag. The relationship has flipped, in the last 30 years where if GDP growth goes up the rate of spending growth probably declines.
The present economy has numerous automatic stabilizers such as unemployment compensation, food stamps, bank deposit insurance and others that automatically increase Federal spending when the economy weakens. These stabilizers are more numerous and larger than they were in Keynes' time. So now instead of spending going down when growth weakens it goes up. For the time period October 1981 to the present this inverse relationship has the strongest correlation with GDP leading spending by 3 months, or you could say spending lags 3 months. The chart below shows the correlation. The downward slope of the best fit line in the scatter plot means an inverse correlation where rising GDP growth corresponds with weaker spending growth. The inverse relationship is shown in the time series plot with the red scale for spending growth on the left being inverted.
Annual GDP growth has not made any significant change in the last three months and so does not imply any significant influence on spending in the next three months.
The theory that increasing Federal spending spurs growth has lots of appeal particularly to groups upon whom the money is spent. If there is positive relationship between spending and growth when does the positive effect on growth from increasing spending occur? It doesn't occur in 12 months. At 12 months the correlation is weaker, but still negative. The implication (which I do not believe) is that growth will strengthen next year.
With a 28 month lead time (chart not shown) the correlation goes to zero and the best fit line would be flat. A positive relationship appears to develop after 29 months of lead time. The strongest positive correlation I found for the time period was with spending leading 45 months, shown in the chart below.
Here the best fit line has a positive slope and the red scale for growth in spending is right side up at the right of the chart. If these lead times are to be believed the increase in spending going into the great recession should have a positve affect on growth in the next 2 years. A cut in Federal spending at the beginning of 2013 would not even began to have a negative impact on growth for at least 29 months or about mid 2015. The impact might not be significant until 45 months or about the end of 2016.
So we don't need to fear the effect of spending cuts anytime soon. Frankly, I don't think we need to fear them at all. The positive correlation shown may not be significant. The positive slope may be the result of an outlier, more specifically the surge in growth that peaked in 1984. This surge is probably explained by factors other than Federeal spending like growth bouncing higher from the back to back recessions of 1980 and 1981-82. The relationship is not statistically significantof if you exclude this surge as the chart below which starts the correlation in mid 1985 shows. If the relationship is not significant there is no reason to expect the surge in spending from the great recession will improve growth in the near future.
Trying to understand the influence that a change in spending has on growth reminds me of when I studied economics in college. In the first year we were taught about the multiplier effect, how when government spent an additional dollar if might work its way through the economy several times and increase GDP by several dollars. In the third and fourth year we learned of more complicated models where to spend an additional dollar the government had to borrow that dollar and borrowing the dollar took the dollar out of the private sector and might crowd out any beneficial effect of the government spending an extra dollar.
In the intervening years I have come to be skeptical of economic theory. If I can't find a correlation in data that supports a theory, I tend to think the theory lacks adequate context or is just a logical sounding hypothetical with no basis in reality.
I can't claim to understand all the context of why increasing government spending appeared to be good for growth historically, but not good for growth in the last 30 years. I suspect government debt has something to do with it.
Much of the fear about cutting spending may be generated by well-heeled recipients of the spending and their lobbyists. The interests of the public might be better served by ignoring these special interests. The last 30 years of data suggest we should have no concern about cutting the growth in Federal spending. The implication of the data suggests outright declines in Federal spending might also be beneficial or at least not harmful. I believe long term prosperity would be more secure and that short term well being would not be harmed if Federal spending headed back down toward about 18% to 20% of GDP and revenue headed up toward about 18% to 20%.
A discrepancy between perception and reality creates investment and trading opportunities. The above correlations suggest a wide discrepancy. The perception appears to be that the spending cuts associated with sequestration would cause a recession and that heading off the cuts improves the outlook for 2013. The correlations above suggest the opposite. So if the stock market (SPY) rallies at the announcement of a deal to head off sequestration it might be a selling opportunity. If it plunges at the failure of a deal it might be a short term buying opportunity.
Additional disclosure: There is no guarantee analysis of historical data and trends enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.