Understanding the House budget plan

John Cogan and John Taylor have an easy-to-understand analysis of the House budget plan that will be voted on this week.

Most importantly, they explain why it is that a reduction in the growth of federal spending can actually stimulate economic activity. Traditional methods of analysis based on flawed Keynesian theories assume that any reduction in spending weakens the economy, and any increase strengthens it. One silver lining to the economic cloud of the past four years is that huge increases in spending (e.g., the ARRA) not only failed to stimulate growth but actually retarded growth. We've just lived through a laboratory experiment in Keynesian economics and found that the theory was dead wrong.

They also explain the importance of incentives, which are missing from Keynesian models, and make the very important point that "the resources to finance government expenditures aren't free—they withdraw resources from the private economy." Since the private economy spends its own money better than the government does, shrinking the size of government—especially when it is as large as it is today—leads directly to a more efficient and stronger economy.

Here's a quick summary of how the House budget plan would help boost economic growth immediately:

First, the lower level of future government spending avoids the necessity of sharply raising taxes. The expectation that tax rates won't need to rise provides incentives for higher investment and employment today.

Second, since the expectation of lower future taxes has the effect of raising people's estimation of future disposable income, consumption increases today. This change comes thanks to Milton Friedman's famous "permanent income" hypothesis that the behavior of consumers reflects what they expect to earn over a long period. According to our macroeconomic model, the higher level of consumption induced by the House budget's effect on consumer expectations is large enough to offset the reduced growth of government spending.

Third, the new budget's reduction in the growth of government spending is gradual. That allows private businesses to adjust efficiently without disruptions.