Federal deficit collapses, economy doesn't

As the economy celebrates six years of recovery, we should all celebrate the massive decline in the federal deficit. It's good news for the future, because the expected future burden of taxation has declined significantly, and because we've now proved that Keynesian economic theory doesn't work—the deficit collapsed but the economy didn't. The magical solution was growth, not government spending, and that should help steer the course of future fiscal policy in a more growth-friendly direction: less reliance on government stimulus and more reliance on increasing the after-tax rewards to work and risk-taking. 

The recovery is now six years old. During that time, 12-mo. federal revenues have increased 47% (from $2.18 to $3.21 trillion) and federal spending has increased only 6% (from $3.43 to $3.64 trillion).

With spending held relatively steady while the economy grew, spending relative to GDP has declined from a high of 24.4% of GDP to 20.3%. That's only about 1 percentage point above its post-war average of 20.3%. Meanwhile, revenue growth has far outpaced overall economic growth (as it usually does during recoveries), with the result that revenue relative to GDP has risen from a low of 14.2% of GDP to 18.1%. That's a little less than 1 percentage point above its post-war average.

The happy result of all this is a sharply lower federal deficit. In the past 12 months, the federal deficit was $431 billion, only 2.2% of GDP. The decline in the deficit from a high of 10.2% to today's 2.2% is unprecedented in post-war history. If any Keynesian economist at the end of 2009 been asked to predict what would happen to the economy if the deficit were to fall by 8 percentage points over the next 5 ½ years, he or she would have predicted disastrous growth, and most likely another recession.

There's a huge lesson here: just as the biggest jump in the deficit in the modern era—fueled by emergency spending—failed to stimulate the economy, the huge decline in the deficit failed to crush the economy. The economy has been growing at 2-2.5% on average per year for the past six years, despite massive swings in the deficit. Keynesian theory thus been totally discredited. There is no reason to raise tax rates, and there is no reason to try to "stimulate" the economy by increased federal spending. The private sector, left to its own devices and given greater breathing room as the result of a shrinking public sector, is perfectly capable of generating jobs and delivering higher living standards for everyone in the coming years.