Correlation Does Not Equal Causation - Government Spending Style

by: Cullen Roche

Some people out there want you to believe that government spending is always bad. In most cases, they would like you to believe that governments should be run just like a household and balance their budgets or save before they then invest. MMTers know this is sheer nonsense as we understand that an autonomous fiat currency supplier is the currency ISSUER while a household, business or state is always a currency USER. One group that loves to push this myth is supply side economists. It’s generally a political argument against big government and unfortunately, it’s based largely on defunct neoclassical myths. What they generally say is something like this, with scary chart (via Scott Grannis):

The federal budget numbers for September, released today, didn’t show anything encouraging. Revenues came in on the weak side, and the fiscal 2011 deficit was almost exactly $1.3 trillion, second only to the record-setting $1.4 trillion in fiscal ’09. Using my estimates for Q3/11 GDP growth, I figure that federal spending is currently running at almost 24% of GDP. If we don’t slow the growth in discretionary spending and reform entitlement programs, then the blue line is almost sure to go higher in the future.

To the untrained eye, this is a very scary chart. It appears to show that the government’s spending is causing the high unemployment rate. But as they say, correlation does not always equal causation. The problem with this chart is that government spending as a % of GDP always increases during a recession. This is due to several reasons – some of which are just basic arithmetic surrounding the way an economy expands and contacts. For instance, when the economy contracts, government spending actually jumps as a percentage of GDP as unemployment benefits increase, income tax receipts decline and pre-established fiscal spending continues undisturbed. So, if you have a budget deficit of $1.5T for 2012 (10% of GDP) and our economy contracts 10% in the coming year (extreme examples make for ease of illustration) our government spending as a % of GDP will actually jump to 11.1%. In fact, it will actually be much higher than that in our example because tax receipts will collapse and other automatic stabilizers will surge. So, there will be an appearance in the data as though the government spending correlated highly with the recession and might have even caused it. But that’s not an accurate picture of the way these events are unfolding. Not even close. Now, this is not to say that government spending can’t negatively impact the economy, but I hope you get my point.

Perhaps more important is a real point of correlation and causation. And that’s our work on sectoral balances. Unfortunately, most mainstream economists never studied Wynne Godley or were exposed to his brilliant work. But it’s a powerful display of correlation and causation. What his work shows is how the government’s deficit is the non-government’s surplus. It shows that (I – S) + (G – T) + (X – M) = 0. But again, you won’t find this in your mainstream economics classes taught by professors who reside in a defunct paradigm and now poison the minds of the youth taking on astronomical student loans to learn an inaccurate form of economics.

Sadly, the first chart above (from Grannis) is easy to understand while stock/flow consistent macro is not. So you get comments like Grannis’s conclusion which sound quite logical at first blush:

cutting back on the size of government would boost the economy and lower the unemployment rate. If the big boost in spending only weakened the economy, then cutting back on spending should help.

This is the same sort of mentality that is pulverizing many of the periphery European nations. Unfortunately, these aren’t normal times and with the private sector so abnormally strained (and our country running a current account deficit), there is, BY ACCOUNTING IDENTITY, only one sector of the economy that can pick up the slack. If we fall for this fear-based political rhetoric we’ll find ourselves suffering the same sort of economic weakness seen in nations like Greece. And while we have no risk of a solvency crisis like Greece (who is a currency USER in the EMU), we are certainly at risk of political ignorance based on the misguided perspective of economists who live in a defunct paradigm.

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