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Do government dollars drive recovery?

The conventional wisdom and data behind government spending during recessions

Conventional wisdom suggests that, once you determine the appropriate level of government spending on goods and services, this level should grow more or less in line with the growth of the broader economy. Keeping the growth rate of government spending stable over the business cycle helps stabilize the business cycle.

But let’s see what the data show: The FRED graph above plots (1) the percentage change year-to-year of total government spending on goods and services and (2) the employment-to-population ratio. The three shaded regions in the graph represent periods of recession, each characterized by a rapid decline in employment followed by a gradual recovery. But the growth in nominal government spending wasn’t the same across these three recessions: It decelerates in the early 1990s recession, remains relatively stable in the early 2000s recession, and declines precipitously into negative territory in the most recent recession.

The recessions themselves were also different: The recession in the early 2000s was noticeably mild. Was this in part due to the stable pace of government spending? In contrast, the 2007-09 recession was very deep and had a very slow recovery. Was this in part due to the unprecedented cuts in government spending? At the state and local level, these cuts were made largely in response to diminished state tax revenue and the inability to issue debt. At the federal level, they were motivated more by unwillingness to expand the federal debt even further.

Austerity during a downturn may have its merits. But the fiscal retrenchment during the most recent recession almost surely contributed to the recession’s severity and very slow recovery. Given that interest rates and inflation remained unusually low, it seems difficult to justify the sharp cyclical cuts in government spending that took place at that time. If a smaller government spending program is a long-term policy goal, the textbook recommendation is that this policy should be implemented only after the economy has fully recovered from recession.

How this graph was created: Search for “Government Consumption Expenditures and Gross Investment (GCE).” From the “Edit Graph” panel, change “Units” to “Percent Change from Year Ago.” Select “Add Line” in the same editing panel and search for the “Employment Population Ratio: 25 – 54 years.” Select the first result. Under “Edit Line 2” (still in the same editing panel), change “Units” to “Percent.” Finally, change the start and end dates on the graph to “1990-01-01” and “2019-12-01.”

Suggested by David Andolfatto and Mahdi Ebsim.

View on FRED, series used in this post: GCE, LNS12300060

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