Is the problem out of control spending, or an economy not growing at full potential? This post will definitively answer that question.

Consider the following figures from the St. Louis Federal Reserve:

2007 Q4 GDP: $14 trillion
Revenue: $2.7 trillion
Outlays: $2.9 trillion

2008 Q2 GDP: $14.4 trillion
2009 Q2 GDP: $13.8 trillion
2010 Q2 GDP: $14.4 trillion
2011 Q2 GDP: $15.0 trillion

2012 Q4 GDP: $15.2 trillion
Revenue: $2.4 trillion
Outlays: $3.79 trillion

The two big figures are 2007 and 2012, but I threw in the intervening years as a needed reminder about what happened to the economy besides jobs lost. In fact, this is the most important thing you need to think about: GDP contracted and unemployment increased between 2007 and mid-2009. The economy was not (and still isn't) running at 100%. That's what economists call Potential GDP, or what GDP would be if unemployment were at 4% (considered normal, or full.)

With unemployment at around 7.8-8.4% throughout last year and much higher in previous years, the economy wasn't growing as fast as it could have. Because of that, things like government revenue and spending aren't what they should be, either. One of these sets of numbers without the other is only having half the picture. If you use them together, you can tell roughly how much the increase in spending in the last four years is the result of depressed demand (growing, but not fast growing GDP).

Q4 2007 was the most recent quarter where GDP and PGDP were roughly the same: $14.224 trillion PGDP, and $14.253 actual GDP, because of about 4.7% unemployment. That's why I picked 2007, it's a good baseline. That was "normal".

Here's what 2012 Q4 would have looked like had we been at full employment the entire time:

2012 Q4 PGDP: $16.8 trillion

Now that we know what economic output should have looked like last year without the recession, let's adjust spending and revenue so that they both grew by the same amount that GDP would have, about 20% in four years:

2008 Revenue: $2.7 trillion
2012 Revenue: $2.4 trillion
2012 Revenue: $3.24 trillion (Potential GDP)

2008 Outlays: $2.9 trillion
2012 Outlays: $3.79 trillion
2012 Outlays: $3.48 trillion (Potenial GDP)

Just on tax revenue alone, the federal government should be seeing tax receipts at least $840 billion higher. And it should be spending about $310 billion more for the same reason. Lost revenue and increased recession spending account for 88% of the 2012 deficit, about $1.15 trillion out of $1.3 trillion.

The 2012 structural (non-recession) deficit as I've calculated it is about half the 2004 deficit when nobody was complaining about out-of-control spending.

So there's your answer. "Out of control spending" is a political urban legend with no data to support it, while "the recession plus $190 billion in new spending" is the correct answer.

* * *

Although I don't understand this aspect of economics very well, it's my understanding that what I've explained above is also the reason that things like interest rates and inflation didn't increase while the Fed doubled or even tripled the monetary base by printing money and either having the Treasury hand it to Wall Street through $16 trillion in secret loans, or through quantitaitve easing (which I guess is roughly the same thing, except we never get that money back.)

That is probably why Paul Krugman keeps saying that recent history (the last four years) has both proven Kenysian economics correct yet again, but also has proven basic macroenomics correct as well.

In other words, GDP being at $15.2 trillion at ~8% unemployment when it could be $16.8 trillion at ~4.5% unemployment is the what we're talking about when we use the terms "liquidity trap" and "demand-supressed" economy. We won't ever be Greece because we have our own currency and can print money and issue debt at will, and we won't be the Weimar Republic because of the output gap (GDP vs Potential GDP).

Such arguments are based on a fundamental ignorance of economics, and ignorance even greater than mine which is quite substantial.

One of the reasons I have a lot of faith in my arguments and very rarely back down is because I usually don't make an argument unless it's internally consistent in my head. It has to do more than just make sense and have some favorable data, an idea has to connect perfectly from A to C when you're only talking about A and B.

And usually for me to feel comfortable with it, I have to make those connections myself. While writing this post, that's something that just happened for me. I've heard over and over from Krugman that printing money in a liquudity trap is not inflationary, but not until tonight did I realize that it was because of the output gap. The output gap explains why, even though there are already mountains of data all over the place that prove the idea to be true. We've been printing money like mad for four years and treasury bill interest rates just keep falling, month after month.

Now it all makes sense.