The conventional wisdom seems to be that our biggest economic challenge is runaway government spending. The reality is that government spending is contracting and pulling economic growth down with it.  And worse is yet to come.

Perhaps the best measure of active government intervention in the economy is something called “government consumption expenditure and gross investment.”  It includes total spending by all levels of government (federal, state, and local) on all activities except transfer payments (such as unemployment benefits, social security, and Medicare).  

The chart below shows the yearly percentage change in real government consumption expenditure and gross investment over the period 2000 to 2012 (first quarter).  As you can see, while the rate of growth in real spending began declining after the end of the recession, it took a nose dive beginning in 2011 and turned negative, which means that government spending (adjusted for inflation) is actually contracting.

The next chart, which shows the ratio of government consumption expenditure and gross investment to GDP, highlights the fact that government spending is also falling as a share of GDP.

Adding transfer payments, which have indeed grown substantially because of the weak economy, does little to change the picture.  As the chart below shows, total government spending in current dollars, which means unadjusted for inflation, has stopped growing.  If we take inflation into account, there can be no doubt that total real government spending, including spending on transfer payments, is also contracting. 

The same is true for the federal government, everyone’s favorite villain.  As the next chart shows, total federal spending, unadjusted for inflation, has also stopped growing.

Not surprisingly, this decline in government spending is having an effect on GDP. Real GDP in the 4^th Quarter of 2011 grew at an estimated 3 percent annual rate.  The advanced estimate for 1^st Quarter 2012 GDP growth was 2.2 percent.  A just released second estimate for this same quarter revised that figure down to 1.9 percent.  In other words, our economy is rapidly slowing.

What caused the downward revision? 

The answer, says Ed Dolan, is the ever deepening contraction in government spending:  

What is driving the apparent slowdown? It would be comforting to be able to blame a faltering world economy and a strengthening dollar, but judging by the GDP numbers that does not seem to be the case. The following table (see below) shows the contributions of each sector to real GDP growth according to the advance and second estimates from the Bureau of Economic Analysis. Exports, which we would expect to show the effects of a slowing world economy, held up well in the first quarter. In fact, the second estimate showed them even stronger than did the advance estimate. The contribution of private investment also increased from the advance to the second estimate, although not by as much. Exports and investment, then, turn out to be the relatively good news, not the bad, in the latest GDP report.

Instead, the largest share of the decrease in estimated real GDP growth came from an accelerated shrinkage of the government sector. The negative .78 percentage point decrease of the government sector is the main indicator that we are already on the downward slope toward the fiscal cliff.

If current trends aren’t bad enough, we are rapidly approaching, as Ed Dolan noted, the “fiscal cliff.” That is what I was referring to above when I said that worse is yet to come. As Bloomberg Businessweek explains:  

Last summer, as part of its agreement to end the debt-ceiling debate (debacle?), Congress strapped a bomb to the economy and set the timer for January 2013. Into it they packed billions of dollars of mandatory discretionary spending cuts, timed to go off at exactly the same time a number of tax cuts [for example, the Bush tax cuts and the Obama payroll-tax holiday] were set to expire  

The congressional deficit supercommittee had a chance to disarm the bomb last fall, but of course it didn’t. And so the timer has kept ticking. The resulting double-whammy explosion of spending cuts and tax increases will likely send the economy careening off a $600 billion “fiscal cliff.”

The fiscal contraction will actually be even worse, since the extended unemployment benefits program is also scheduled to expire at the end of the year.  

So, what does all of this mean?  According to Bloomberg Businessweek:

If Congress does nothing, the U.S. will almost certainly go into recession early next year, as the combo of spending cuts and tax hikes will wipe out nearly 4 percentage points of economic growth in the first half of 2013, according to research by Goldman’s Alec Phillips, a political analyst and economist. Since most estimates project the economy will grow only about 3 percent next year, that puts the U.S. solidly in the red.

One can only wonder how it has come to pass that we think government spending is growing when it is not and that it is the cause of our problems when quite the opposite is true.  Painful lessons lie ahead — if only we are able to learn them.