What Every American Needs To Understand About The Economy

As the United States debates its economic future in light of large government budget deficits, it is important that the public has a clear understanding of how the economy works. A good starting point for understanding how the economy works is to understand how it is measured.

Economies are measured in terms of their Gross Domestic Product or GDP. GDP is made up of personal consumption expenditure, private investment, net trade (i.e. exports minus imports) and government spending at both the federal level and the state and local level. If the size of each of these components is known, it is only necessary to add them together to find the size of the whole economy. In 2009, the United States GDP was $14.1 trillion, according to the Bureau of Economic Analysis (BEA). Of that amount, spending on personal consumption accounted for 71% or $10 trillion; private investment 11% or $1.6 trillion; and government spending 21% or $2.9 trillion, with federal government spending of $1.1 trillion and state and local government spending of $1.8 trillion. Net trade deducted 3% or $390 billion from GDP because exports from the US were $390 billion less than imports into the US.

So, what is the outlook for the US economy? The outlook for personal consumption is bad because the household sector is heavily indebted. Household debt increased from 64% of GDP in 1998 to 97% of GDP in 2008. At that point, millions of Americans became unable to repay their debt, defaulted, were cut off from additional credit and were forced to spend less. The drop in private spending threw the world into economic crisis and caused US unemployment to soar to 10%. Prospects remain discouraging because home prices have fallen by more than 30% on average, meaning that even the Americans with good credit ratings have much less collateral to borrow against. With limited access to credit, household spending will remain depressed.

The outlook for private investment is also bad. Capacity utilization, which measures the extent to which factories are operating relative to their capacity, is roughly 75%. This is one of the lowest levels since records began in the 1960s. Businesses will not invest more at a time when they cannot utilize the capacity they have already put in place.

Net trade has deducted from US GDP every year since 1975 because the United States imports so much more than it exports. There is no reason to expect this to change given current government policies.

That leaves government spending. The figures for government spending mentioned above are actually misleading in the sense that they underestimates the true impact of government spending on the economy. For instance, as classified by the Congressional Budget Office, federal government outlays actually amounted to $3.5 trillion in 2009, three times the figure shown above. The explanation for this large difference is that the amount reported for the federal government in the GDP data provided by the BEA represents only the federal government’s direct purchases of goods and services. It excludes normal transfer payments such as unemployment benefits, Social Security payments, Medicare, and assistance to state and local governments, as well as emergency assistance to the financial sector. In other words, federal government transfers provide significant support to other sectors of the economy, particularly personal consumption expenditure and state and local government. Therefore, the contribution to GDP of those sectors is actually overstated in the BEA data, while that of the federal government is understated.

At a time when government spending is under fierce attack in the United States, every American needs to understand how much of the economy depends on that spending. This year the US budget deficit will be approximately $1.4 trillion. If the federal government were to attempt to balance its budget by spending US$1.4 trillion less in 2011, the reduction in government spending would not cause personal consumption or private investment to increase. To the contrary, both would decline. Personal consumption would decline because less government spending would cause unemployment to rise sharply; and private investment would decline because there would be much lower demand for goods and, consequently, much lower levels of capacity utilization than exist now. Moreover, as consumption and investment declined, tax revenues would also decline, making it necessary for the government to cut its spending even further to balance its budget.

In the past, it was understood that if the government spent less and borrowed less then interest rates would fall since there would be less demand for loans. Lower interest rates would then boost the economy by allowing businesses and consumers to borrow at cheaper rates and to spend more. That is not the case now, however. Short-term interest rates in the United States are very near 0%. They will not go lower if the government spends less. What this means then is that the economy will contract by more than the amount that the government reduces its expenditure – and, perhaps, much more.

Of course, the US government cannot continue to run trillion dollar budget deficits forever. Therefore, if the United States is to avoid eventual economic ruin, we must shift the national debate away from slashing government spending regardless of the consequences and instead discuss how the government could spend that money in a way that generates a high return on investment. In other words, the sensible approach is to shift the government spending away from areas that support consumption to areas that boost investment. A smart investment strategy would allow the United States to develop new, high-tech industries that would boost US exports, reduce US imports, create US jobs and generate significantly higher tax revenues.

It is simple minded to dismiss this idea as “Un-American”. Today, many of the United States most successful export industries, including agriculture and defense, are supported by US trade barriers, direct government subsidies, or both; while, historically, the United States industrialized during the 19th century behind a high wall of tariff protection.

The United States is in crisis. Before we can reach the point where the government can spend less, the country must go through a period where the government spends much more wisely. To simply slash government spending now would result in a depression in the United States and around the world. Just do the math.


Richard Duncan
for The Daily Reckoning

P.S. For more perspective from Richard Duncan you can visit his blog on economics in the age of paper money at www.richardduncaneconomics.com.