The government and short-run economic growth

By :: January 31st, 2013

Economic growth estimates released yesterday were not good news: the economy contracted in the fourth quarter for the first time since 2009, albeit by just 0.1 percent. Commentators have mostly attributed the mild contraction to a steep drop in federal defense spending and reduced inventories—each factor cut the quarter’s growth by about 1.25 percent on an annual basis. Those factors are likely temporary and probably won’t drag down future growth unless Congress fails to address the sequester in the next few weeks and defense spending takes a sustained hit.

A less noted problem is the continuing contraction in state and local government spending. State and local government consumption and investment have declined in 12 of the last 14 quarters (see chart). Such a continued contraction is unprecedented since World War II, and is even more surprising considering that these 14 quarters have followed the recession’s trough.


Economic growth over the past two years would have been respectable if not for the drag by local, state, and federal governments. If the government sector had maintained real consumption and gross investment in 2011 and 2012—that is, if its contribution to GDP growth had been zero—overall economic growth in each of those years would have been around 2.5 percent.

Perhaps today’s report will help members of Congress realize that government spending matters for short-run economic growth. Perhaps lawmakers of both parties will see that if the budget stand-off continues, and the deep federal automatic spending cuts now scheduled for March kick in, last quarter’s contraction could turn into a more sustained slump. Perhaps they’ll realize that there may be times for fiscal austerity, but that’s certainly not when our economic recovery is still so weak.