Why a shrinking government is bad news

By Rick Newman

Americans generally want smaller government, and the lower taxes that go with it. They're starting to get their wish—but it spells trouble for the broader economy.

The latest jobs data shows that the private sector added 130,000 jobs in April, while the government sector lost 15,000, for a net gain of 115,000 jobs. The longer-term trend is more stark. Since the start of 2011, the private sector has added 2.8 million jobs, while government has shed 280,000 jobs.

On the whole, this may be a fitting realignment for an economy that got too dependent on public spending. But the economy is also beginning to suffer withdrawal symptoms from shrinking government that are causing collateral damage elsewhere. The loss of government jobs in April contributed to a discouraging jobs report, which could have a lasting effect on the economy. The weak report "has increased concerns that growth in the U.S. economy is slowing down," writes Dick Green of Briefing Research. "The associated anxiety may create a cautious undertone to market sentiment that could take months to dispel."

A bigger issue that economists are starting to worry about is that much sharper public-sector cutbacks are coming toward the end of this year, and especially in 2013. Most of the government jobs lost so far have been at the state and local level, as states and cities have cut spending on teachers, public safety, and other types of services to cope with falling tax revenue. The federal stimulus money appropriated in 2009—which plugged a lot of holes at the state and local levels--has mostly run out as well, with tax revenues not rebounding strongly enough yet to make up the shortfall.

State and local cutbacks, however, are mild compared to what's supposed to happen at the federal level. The Bush-era tax cuts, for one thing, expire at the end of the year, and if they're not extended, most Americans will endure sudden, punishing tax hikes.

Most analysts expect a last-minute extension, but that might require offsetting cuts in other types of government spending in order to keep the national debt from growing even more than it already is. Such spending cuts would come on top of nearly $1 trillion worth of cuts already scheduled to kick in starting in 2013.

Those spending cuts are just what Tea Party activists and small-government advocates want. But shrinking government, while the economy is weak, can be like delicate surgery, with a lot of damage possible if the scalpel slips. If all of the measures on the table were to go into effect, for example, economist say it could cut three to six percentage points off of GDP growth—which would instantly induce a recession. This is the "fiscal cliff" that Federal Reserve Chairman Ben Bernanke and others have warned about. "I'm very worried," said Citigroup chief economist Willem Buiter at the recent Milken Institute conference in Los Angeles. "I see complete paralysis."

Republican presidential front-runner Mitt Romney has suggested that he'd take an ax to the federal bureaucracy, killing some agencies and shrinking others. But the problem with the federal government isn't really the size of the workforce. Over the last 10 years, for example, the federal workforce has grown by only 2.3 percent, which is a bit more than the private sector has grown, but far less than the nation's population growth. The real problem is the explosive growth of entitlement spending, especially on Medicare and Social Security, which for the most part doesn't require any extra workers.

But Medicare and Social Security are popular programs that will be very hard to cut back. So for now, politicians are targeting cutbacks in the federal workforce, which is an easier sell to voters. As long as they don't look too far into the future.

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