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Kudlow: Sequester Will Grow Private Economy

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Wednesday's report of a 0.1 percent gross domestic product decline for the fourth quarter came as a surprise to most forecasters. But it actually masks considerable strength in the private economy.

Namely, housing investment in the fourth quarter jumped 15.3 percent annually, business equipment and software spiked 12.4 percent, and real private final sales rose 2.6 percent. All in, the domestic private sector of the economy increased 3.4 percent annually—a very respectable gain.

(Read More: The 'Best-Looking' GDP Drop You'll Ever See.)

And here's one for the record books: Working ahead of year-end tax hikes, individuals shifted so much money to the fourth quarter at the 35 percent top rate that personal income grew by 7.9 percent annually—a huge number. And there's more: In order to beat the tax man, dividend income rose 85.2 percent annually. You think tax incentives don't matter? Guess again.

(Read More: Federal Reserve to Continue Stimulus Amid Signs of Weak Economy)

Now, all this private-sector strength occurred despite the fact that government spending—namely military spending—dropped 6.6 percent. Inventories also lost ground and the trade deficit widened.

But here's a key point: Military spending has now fallen virtually to its lower sequester-spending-cut baseline. It did so in one quarter by about $40 billion. So the brunt of the impact over the coming years has already been felt. (Normally, as of recent years, military spending has been virtually flat.)

(Read More: Why Markets Aren't Worried About Bad GDP Report)

Which leads me to another key point: Even with the fourth-quarter contraction, the latest GDP report shows that falling government spending can coexist with rising private economic activity.

This is an important point in terms of the upcoming spending sequester. Lower federal spending, limited government, and a smaller spending-to-GDP ratio will be good for growth. The military spending plunge will not likely be repeated. But by keeping resources in private hands, rather than transferring them to the inefficient government sector, the spending sequester is actually pro-growth.

Big-government Keynesians think big spending provides big growth. They are wrong. This has been a 2 percent recovery—the worst in modern times—dating back to 1947. So let's try something different. Let's shrink government. Let's let the private sector breathe and generate entrepreneurship and risk-taking.

Spending is the true tax measure of the economy, according to Milton Friedman, Friedrich Hayek, and others. Even a modest sequester spending cut of maybe $60 billion in 2013, and perhaps more than $1 trillion over ten years (most of which will come from a slower spending growth rate, not real reductions), will be the best thing to inspire business and market confidence as well as international credibility. And it maybe even shave a point or two off the spending share of GDP.

(Read More: Op-ed: Bring On the Sequester!)

On March 1 the spending sequester is supposed to kick in by law. If Congress wants to help the U.S. economy, the best thing it can do right now is implement this sequester. Then it can round out an even larger growth package, including large- and small-business tax reform and adjustments to stop entitlements from going bankrupt.

—By CNBC's Larry Kudlow; Follow him on Twitter @larry_kudlow

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