Cutting Spending in the US: Can It Be Done

Cutting Federal Government Spending: Yes We Did

David R. HendersonResearch Fellow, Hoover Institution,

Stanford Universityand

Associate Professor of Economics, Graduate School of Business and Public

Policy Naval Postgraduate School

Me with Former President Reagan, January 1993

Canada’s Budget Triumph

Federal spending on programs (as a percent of GDP):

• 1992-1993: 17.5 percent• 2000-2001: 11.3 percent

Canada’s Budget Triumph (cont)

Federal spending on servicing the federal debt (as a percent of GDP):

• 1992-1993: 5.6 percent• 1999-2000: 4.3 percent

What is a “Cut”?When analysts refer to government budget cuts, they do not all use the word “cut” the same way. A cut in government spending can mean one of four things:(i) A cut in the dollar amount of spending even

when there is inflation;(ii) A cut in real spending, that is, an inflation-

adjusted cut;(iii) A cut in spending as a percent of GDP;(iv) A cut in the planned increase in spending.

America’s Budget Triumph

Defense Spending as % of GDP

Net Interest on Debt as a % of GDP

The Big Three

Other Domestic Spending

Fell from:

• 6.41 percent of GDP in 1990 to • 5.40 percent in 2000

Was High Economic Growth in the 1990s an Important Cause?

Average annual economic growth by decade:

• 1990s: 3.2 percent• 1980s: 3.2 percent• 1970s: 3.2 percent

Did Cuts Hurt Growth?

Growth in last half of decade, 1995-2000, after most of the cuts had kicked in:

• 4.0 percent annual average real GDP growth

Due to United Legislative/Executive, as in Canada?

No.

1990-1992: R Pres, D Congress1993-1994: D Pres, D Congress1995-2000: D Pres, R Congress

Earlier Evidence: Drop in Post WWII Federal Spending

Post WWII Growth of Real Private GDP

Moral of the Story

Modest cuts in spending (in real terms), combined with keeping growth in spending below growth in GDP, will ultimately balance budgets and even produce budget surpluses.

Where Cuts Can Be Made?

Defense spending today, at about 3.8 percent of GDP, is below where it was at the start of the 1990s, when it was about 5.2 percent.There is still room to cut defense spending substantially.

But the growth in government spending in the future will be mainly in Medicare, Medicaid, and Social Security.

The Danger of Our Current Debt

• Net interest on the debt is very low.• This is because the interest rate on the

debt is low.• Even a one-percentage-point rise in

interest rates on the approximately $12 trillion in debt held by the public would increase government spending by a hefty $120 billion. This is about 0.75 percent of GDP.

Solution: Lock in Low, Long-Term Interest Rates

• Short-term problem: If we lock in long-term rates on, say, $3 trillion of debt, debt service on this $3 trillion immediately rises by $90 billion.

• Long-term benefit: If interest rates rise by more than 3 points, feds will save money.

• Diversified strategy: That’s why I chose $3 trillion.

Yes We Can – Cut Federal Spending