Ugly modeling: will spending cuts ruin or improve America's economy?

• Author: de Rugy, Veronique
• Position: Column

IN FEBRUARY, the Goldman Sachs economist Alec Phillips predicted on ABCNews.com that a Republican proposal in the House of Representatives to cut $61 billion from the federal budget in fiscal year 2011, would, if enacted, shave two full percentage points off America's gross domestic product in the second and third quarters of this year. A few days later, The Washington Post described a new study by Mark Zandi, the chief economist at Moody's Analytics and an architect of the 2009 stimulus package, a.k.a. the American Recovery and Reinvestment Act. Zandi's amazing verdict: The spending cuts would destroy 700,000 jobs by the end of 2012.

After every newspaper had published the gloomy predictions, Goldman Sachs issued a "clarification" of Phillips' analysis. Phillips now says he was misunderstood by journalists eager to spread a doom-and-gloom message and predicts the impact of spending cuts probably will be mild and temporary. Perhaps he was influenced by Federal Reserve Chairman Ben Bernanke, who testified in March at the Senate Banking and Urban Affairs Committee that Goldman's numbers were incorrect.

Yet even this correction implicitly assumes that government spending is the source of all recovery. The logic, as with Bernanke's and Zandi's analyses, is that government spending cuts reduce overall demand in the economy, which affects growth and then employment. This argument ignores the fact that the government has to take its money out of the economy by raising taxes, borrowing from investors, or printing dollars. Each of these options can shrink the economy.

All these analysts also systematically ignore the fact that GDP numbers include government spending. When the federal government pumps trillions of dollars into the economy, it looks as if GDP is growing. When government cuts spending--even cuts within the most inefficient programs--aggregate GDP shrinks.

But that's misleading. If Washington spends $1 a year on a bureaucrat's salary, for example, GDP numbers will register growth of exactly $1, whether or not the employee has produced any value for that money. By contrast, if a firm pays an engineer $1, that $1 only shows up in the GDP if the engineer produces $I worth of stuff to sell. This distinction biases GDP numbers--and the policies based on them--toward ever-increasing government spending.

Furthermore, GDP does not capture changes in personal investment portfolios or changes in private research and development spending. In the...