The Economy Gets a Boost From Government

State and local spending is finally adding to GDP growth.
Photographer: Luke Sharrett/Bloomberg

Since the end of World War II, government spending has been a steady contributor to the U.S. economy, accounting for an average of 20 percent of total gross domestic product. But for most of this recovery, the economy has been missing its government partner.

Although the $840 billion stimulus plan helped soften the immediate blow of the financial crisis, by mid-2010 its effects had faded. Lower tax revenue at the state and local levels, combined with the $1.2 trillion in automatic federal spending cuts known as the sequester, shifted government fiscal policy across the U.S. into belt-tightening mode. Along with the drawdown of military operations in Iraq and Afghanistan, lower government spending reduced GDP growth by a total of 7 percentage points from 2010 to 2014, according to the Bureau of Economic Analysis.

Josh Bivens, director of research and policy at the left-leaning Economic Policy Institute, says if the U.S. had reproduced average government spending during the previous three recoveries, the economy would be back to full employment. “If we’d matched the highest level from the 1980s, we would be in an overheating economy,” he says.

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The U.S. is nowhere near that, with growth averaging just 2.2 percent a year through the recovery. But the economy is improving, and in the second quarter total government discretionary spending and investment added 0.46 of a percentage point to GDP growth, its best quarterly contribution since 2010. This does not include social-welfare payments such as Social Security.

Almost all of the gain came from state and local governments, which account for about 61 percent of government spending. After shedding more than 700,000 jobs from 2009 to 2013, states, counties, cities, and towns have added 187,000 so far this year. That’s good, but it doesn’t match hiring in the previous recovery. From 2002 to 2007, states and localities added more than 1 million public-sector jobs.

“The bloodletting is over, but it would take a decade to get [state and local] employment levels back to what they were,” says Jacob Oubina, senior U.S. economist at RBC Capital Markets. With Republicans controlling 70 percent of state legislative chambers and occupying 31 governor’s mansions, state spending is likely to grow slowly. Localities, which get most of their revenue from property taxes, are still spooked by the housing bust, Oubina says.

On the federal side, the sequester remains largely intact four years after it was devised as a way to end the debt-ceiling crisis in 2011. Envisioned as a plan too painful to ever enact, it’s hurt the economy more than many anticipated, says Michael Brown, an economist at Wells Fargo. Given how much the sequester lowered GDP growth, “it’s an open question whether we saved any money at all,” Bivens says. “It’s not a slam dunk that it even lowered the deficit.”

A stopgap bill passed on Sept. 30 avoided a shutdown, but it funds the federal government only until Dec. 11. With John Boehner set to retire as speaker of the House and the Treasury on course to run out of borrowing room in November, it’s possible a long-term budget that eases the sequester’s spending caps can be reached. It’s simply a matter of each side getting something it wants, says Doug Holtz-Eakin, chief economist of the President’s Council of Economic Advisers from 2001 to 2002. “Republicans want more defense spending. The president wants more on the domestic side. The question is whether they can get there.”

The bottom line: Government spending overall will remain muted because of GOP dominance at the state level.

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