Can GDP Growth Outpace Spending in Order to Reduce the Deficit?

No.  That means that increased taxes and austerity measures are on the horizon, though such action is beyond the policy and historical practices of our government.

Yesterday, the G20 published a communiqué endorsing a goal of cutting government deficits in half by 2013 and reducing the ratio of public debt to gross domestic product by 2016.  This means that we must cut our deficit approximately 2% per year. 

GDP (Gross Domestic Product) for a given country is the total of Consumption (personal and business) plus Investments plus Government spending plus exports minus imports.  Keynesian economists argue that when there is a drop in Consumption, due to a recession, that the Government spending must rise to offset the drop.  The theory is that Government spending will stimulate Consumption, eliminating the need for deficits.  Keynes advocated that governments should develop surpluses in good times.  Unfortunately, this does not happen anywhere.

Paul Krugman, a Nobel Laureate and Keynesian economist, today, is promoting continued deficit spending to avoid massive deflation, which would lead to a depression.  Unfettered spending brings the deficit above 10% of the GDP raising the risk of credit rating reduction and potential default.

With this background, we have written commitment, from the G20, to implement austerity measures in order to draw down the deficit by 50% in less than three years.  The problem is that high unemployment translates to lower tax receipts.  Government’s knee-jerk reaction is to raise taxes, causing more drag on the economy – ironic when research, performed by the head of the current administrations Council of Economic Advisors, shows that tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. If you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases.

If the United States Congress had the discipline (which, historically, it has not) to implement austerity measures, such as those now defined in Great Britain and Germany, the result would be a drag on growth.  Bond holders will demand higher interest rates, which would signal inflation.  However, with G20 members being adverse to inflation, there is, instead, a very real risk of deflation.

Deflation and depression versus inflation and recession seem to be the only choices ahead.  Cutting our deficits and reducing the size of governments will NOT be without pain, but now has a monumental sense of urgency.