Investors beware: If continued, the current trend in declining Federal expenditures will result in increased deficits, slower growth and a major stock market pullback.
Those who lived through the Great Depression learned the math of deficit reduction the hard way. Ronald Reagan, who had to look for his first job in 1932, understood that growth cured deficits, not spending reductions. The chart below of Federal Government Expenditures versus GDP growth during the Great Depression shows the immediate negative effect spending cuts in 1932 and 1937 had on growth.
(Click charts to expand)
Reagan's experience made a lasting impression and he reluctantly raised taxes rather than cut spending that might hurt growth. The relationship between growth and deficits is so well understood by economists that the law of motion of government debt* is called "the least controversial equation of macroeconomics."
The faster the growth, the easier it is to reduce the deficit. The chart below of the relationship of public debt to GDP growth shows that deficits only decrease when growth is positive, and decrease faster as nominal growth (real growth plus inflation) goes up.
Note that the area marked "No Man's Land", where growth is negative (recession) and debt decreases, has no data points.
Reducing deficits is a balancing act where you have to make sure that you don't kill growth when you reduce government spending. The safest way to do this is not reduce year-on-year spending but simply increase government expenditures at a slower rate than GDP is growing. Since 1940, the only year-on-year reductions have been after the end of WWII (1946-47) and the Korean War (1954) and both triggered recessions.
The U.S. is in danger of repeating this mistake. Government expenditures have been contracting Quarter on Quarter since the 2nd Quarter 2011. The chart below compares the relative spending from the end of the last five recessions.
Such a contraction is unprecedented during a recovery from a recession and has resulted in the slowest recovery from a recession since before the Great Depression. This explains Fed Chairman Bernanke's repeated cries for fiscal-spending increases.
Comparing the Great Recession to the Reagan recovery shows a much better performance for Reagan, which can all be explained by higher relative government spending.
Even the Expansionary Fiscal Contraction Hypothesis supports spending increases. In situations like today "when current disposable income constrained consumption," budget cuts result in economic contraction, not expansion.
In case you were wondering: Yes, these theories do prove that things will only get worse for the PIIGS until they leave the euro. As Jesús Fernández-Villaverde from the University of Pennsylvania recently said about claims that budgets cuts will improve Spain's deficit, "It is frankly impossible, given that it would aggravate the recession and this would crush state revenues." The same is true for the U.S.
For investors, a year-on-year reduction in government expenditures has always been linked to a stock market decline. The Recession of 1937 resulted in a 45% pull back.
While it is unlikely that government spending will be dramatically cut no matter what party is in power, it also seems unlikely that government spending will be increased to the level that Reagan used to achieve a rapid economic recovery. In the most likely scenario, government spending will be weak or declining slightly, resulting in a continued weak recovery, very anemic profit growth and a sideways market.
If there are significant spending cuts, expect a rapid market collapse. As the collapse will probably occur at the first hint that spending cuts could actually pass, the collapse might actually prevent any major cuts - rinse and repeat until we get some understanding in Washington of basic economics.
* The law of motion of government debt is:
where b is the ratio of debt to GDP, d is the primary deficit, again as a share of GDP, i is the nominal interest rate, g is the real growth rate of GDP, and pi is inflation. Basically, changes in the debt level depend on the primary deficit (dt) plus the interest (i) on existing debt (bt) less real growth (g) and inflation (i). If the effect of budget cuts is to reduce growth and interest rates are already at 0, the debt load must go up. A contraction in growth will reduce tax revenue so the primary deficit will go up. If cuts are big enough to cause an actual recession, the denominator of the Debt to GDP ratio, GDP, will actually shrink, resulting in a further increase in the debt ratio.