Writing in the Wall Street Journal, Phil Gramm and Mike Solon warn that “[u]nrestrained spending would crowd out private economic activity and risk triggering a recession.” True, expanding the government’s share of economic activity would reduce growth and living standards. But their macroeconomic arguments don’t quite work. They seem to think contractionary monetary policy makes government spending growth more damaging. In reality, Uncle Sam’s eating up a larger share of the economy is worrisome no matter what the Fed is doing.
Fiscal politics catches pundits’ attention, but monetary policy is the ultimate backstop for total spending. Gramm and Solon recognize this. They worry that given the Federal Reserve’s efforts to “eliminate excess demand and bring inflation under control,” failing to curb spending growth will squeeze out the private sector at the expense of the public sector. In other words, they argue that the consequences of the debt ceiling debate for the economy’s health are more dire in an environment of contractionary monetary policy.
Gramm and Solon are right on one count: Failing to constrain government expenditures would weaken markets by diverting resources to unproductive purposes. But the problems with excessive government spending exist regardless of the stance of monetary policy. Even if the Fed were implementing expansionary policy, we’d still get productivity-crippling effects from increased government control. Furthermore, the worst-case scenario isn’t a mere recession. It’s a permanent decline in economic growth.
The Fed’s job is determining the level (and growth rate) of total dollar spending in the economy, which can be approximated by nominal gross domestic product (NGDP). Economists call this aggregate demand. Government spending is a component of NGDP, but that doesn’t mean changes in government spending change the level of NGDP. Instead, fiscal policy mostly seems to change the composition of NGDP.
Gramm and Solon err by not distinguishing carefully enough between Fed-determined aggregate demand and the share of economic activity diverted from productive purposes by government spending. “[E]very dollar of the post-pandemic spending surge that the House debt-ceiling bill prevents from being spent is a dollar the Fed doesn’t need to crowd out of private spending to tamp down inflation,” they write.
Suppose the Fed were lowering its interest rate target, rather than raising it. The nominal economy would likely grow, but the fundamental tradeoff between public and private spending remains. The more Congress and the President spend relative to the private sector, the less productive the economy becomes. Government spending is a supply-side issue, not a demand-side issue. Since the incentives for prudential resource allocation are much weaker and the informational environment underpinning spending decisions is much noisier in the public sector, this spending is typically less productive than private sector spending
The story Gramm and Solon tell only makes sense if you don’t make a distinction between reduced spending and reduced resources. When the Fed tightens, it puts a dampening effect on the purchasing power of the dollar. This can temporarily affect real production decisions and investment opportunities, but only to the extent that monetary policy is unanticipated. What matters is the adjustment period for contracting compared to the adjustment period for new information about the stance of policy. Surely many (if not most) private contracts are pricing in Fed tightening. Hence monetary policy changes the desired level of a nominal variable, namely inflation, with minimal impingement on real variables like output and employment. The Fed is driving spending down, but the economy’s inputs—natural resources, labor, and capital—are no more or less abundant than they otherwise would be.
Implicitly (though perhaps unintentionally), the argument made by Gramm and Solon suggests we don’t need to worry about a bloated government when nominal spending is growing. Excessive government spending is a big problem, they claim, because monetary policy is tight. This is wrong. It’s always a big problem. When the public sector strays outside its comparative advantage and starts directing resources to less-valued ends, the real value of production declines. Whether spending diversion means resource diversion depends on the size and scope of government spending, not the stance of monetary policy.
Nor does excessive government spending result in a mere recession, where real GDP and employment temporarily decline but ultimately return to normal. Excessive government spending makes us less productive than we otherwise would be, resulting in a permanently lower level of employment and output. Business cycles are temporary. Unproductive government spending programs might last forever.
Gramm and Solon deserve credit for calling out the fiscal recklessness of congressional Democrats and President Biden. The aggregate results of the behavior they criticize, however, are even more damaging than they suggest. Two cheers for these accomplished economic commentators—with a hearty third if they tweak their story to get the macroeconomics right.