Ron Paul's Impossible Budget

Today Yahoo! News is carrying a story describing Ron Paul's budget proposal.  Among other things, Paul intends to cut $1 trillion in government spending in his first year in office.  Looking at a report on 2011 discretionary spending released by the CBO in October, Paul's $1 trillion figure apparently covers the entire four-year Presidential term.  For the sake of argument, then, let us consider a $250 billion per year cut in government spending.

A $250 billion per year reduction in discretionary government spending would create economic havoc, particularly now when the economy remains weak.

From introductory macroeconomics, the total economic output of the country, Y, as measured by GDP, is

Y = C + I + G + NX

where C is consumption spending, G is government spending, I is investment, and NX is net exports.  The government spending multiplier measures the amount Y increases for an increase in G.  Traditional Keynesian economics purports that the spending multiplier is greater than one: as the government purchases more goods, workers who produce those goods earn more income which is then spent on consumption goods, and so on.  Modern economic analysis suggests the spending multiplier is less than one for at least two reasons: to pay for the increased government spending, consumers anticipate future higher taxes and therefore save money to smooth consumption in the face of lower future after-tax income; and the increase in government borrowing to pay for the spending leads to an increase in interest rates, and hence lower investment.  The fact that short-term interest rates are stuck at zero implies that the government spending multiplier is higher now than in more normal times.  In most analyses, the spending multiplier has a symmetric effect, in that reducing G by $1 lowers GDP by $1 times the government spending multiplier.  For the sake of argument, let's just assume a multiplier of one.

As of 2011Q3, the U.S. GDP was about $15.2 trillion.  $250 billion represents 1.64% of U.S. GDP.  Thus, Ron Paul's budget, assuming a government spending multiplier of unity, would reduce GDP by 1.6% than it otherwise would be in 2012.

Most economists are predicting a bit of a slowdown in 2012 compared to 2011Q4, with estimates for GDP growth typically in the 2%-2.5% range.  With Ron Paul in charge, GDP would grow a paltry 0.4%-0.9% range.

I suspect the 1.6% hit to GDP estimate is, if anything, much too optimistic.  Eliminating entire cabinet-level departments, while perhaps good in the long-run, would cause hundreds of thousands of layoffs, which would have a further impact on the overall economy.  The hit to the DC metro area would be devastating, because not only would government workers be affected, so to would all the contractors that provide services to the government.

While shrinking the size of government and eliminating wasteful spending are noble goals that will increase U.S. economic performance in the long-run, those changes must be made gradually so they do not shock the economy and should be announced at least a few years in advance to give affected parties time to adjust.  Ron Paul's idea of cutting $1 trillion in four years, given the current economic environment, would likely put the economy into a prolonged recession.

Please do not vote for Ron Paul.  Simple analysis reveals his ideas are not feasible.  And don't get me started on his ideas for interfering with the Fed's independence and returning to the gold standard...