Latest Economic Report Highlights Dangers of Further Austerity

by Patrick Lester, 2/1/2013

The latest official estimate of U.S. economic growth, released Jan. 30 by the U.S. Department of Commerce, has provided further proof that budgetary austerity in the midst of a weak economic recovery makes little sense. Despite this, with Congress still considering further budget cuts and across-the-board cuts (called sequestration) scheduled to begin on March 1, there is little evidence that federal policymakers are aware of how much damage they may be doing to the economy.

According to the latest Commerce Department report, the U.S. economy contracted in the fourth quarter of 2012 (October through December) by an annualized rate of -0.1 percent. This was the first time the U.S. economy had contracted since the end of the recession in 2009. According to the report, the principal driver of the contraction was lower defense spending, which dropped by an annualized rate of 22.2 percent compared to the previous quarter. Defense spending alone accounted for a 1.28 percent drop in the nation's economic output for the quarter. A secondary contributor to the economic slowdown was a drop in business inventories.

This drop in defense spending appears to have been due to two factors. The first is that the Pentagon typically slows down its spending this time of year because it is also the beginning of the federal fiscal year, a period when the Pentagon (and other federal agencies) are often working under temporary budget bills and are still unsure what their final budgets will be for the year. The slowdown is a product of administrative caution in the face of budget uncertainty. This year is no different, with most federal agencies currently funded only through March 27.

While spending typically slows during this period, it is generally mirrored by a corresponding increase in spending at the end of the federal fiscal year (July-September), when officials are trying to spend down any unused dollars that are left over in their annual budgets. These spending patterns are typical and commonly repeated from year to year. This past year may have been a bit worse than usual, however, due to a second factor, which was the threat of sequestration. While Congress ultimately delayed sequestration until March, it appears that Pentagon officials may have been slowing spending more than usual because of fears that sequestration might take place starting in January.

While the Commerce Department report highlighted the impact of slower defense spending, however, it said just as much about the impact of lower government spending in general – as well as the damage that could be done by a continued push by many policymakers to reduce spending even further.

This may not have been immediately evident in the report itself. According to the report, nondefense federal spending grew by an annualized 1.4 percent in the same quarter. This was somewhat offset by a drop in state and local spending by -0.7 percent, which meant that these two categories of spending contributed very little to overall growth. Most of the change in government spending, it seems, was due to the dramatic slowdown in defense spending.

But this conclusion undervalues the importance of domestic spending. First, domestic spending may simply be less subject to variation from quarter to quarter than defense spending. When viewed across the entire year, federal domestic spending actually has contributed more to economic growth over the past two years than defense spending.

Just as important, however, is the fact that the full impact of domestic spending is undervalued in the official economic estimates. These estimates do not include spending on entitlement programs like Social Security, Medicare, and unemployment insurance because they are considered "transfer payments" rather than payments in return for a good or service. The economic contribution of these programs is instead buried within consumer spending numbers (e.g., when someone spends some of their Social Security check on groceries).

And finally, if our attention shifts away from economic growth to jobs, several studies (including this one), have shown that money spent on nondefense programs (such as health and education) produces more jobs than the same amount of money spent on defense. A corollary is that cutting spending on health and education causes more job loss than cuts in defense. This is an important point that has been missed in most of the media coverage of the latest economic report. The focus on slower defense spending misses much of the story.

Nevertheless, the latest economic report from the Commerce Department has done a good job highlighting the important contribution that government spending makes to economic growth overall. Alan Krueger, Chairman of the White House Council of Economic Advisors, used the numbers to generate the following graph, which illustrates the contribution of public spending to overall economic growth. As can be seen, higher government spending helped ameliorate the recession from 2008-2009, but lower spending (due to budget cuts) has caused government to be a drag on economic growth since then.

Components of GDP 4th Quarter 2012
click to enlarge

An even better indication of the potential impact of spending cuts can be found in the latest economic forecast from the Congressional Budget Office (CBO), which last August predicted that sequestration, if it occurred, would trim about 0.8 percent from overall economic growth this year. That estimate is expected to be updated by CBO on Feb. 4.

More broadly, according to several private estimates, the just-completed fiscal cliff deal (which primarily affected taxes, not spending) is expected to trim anywhere from 1-1.7 percent from economic growth this year. With economic growth averaging 1.8-2.4 percent over the past three years, combining the negative impact of the just-passed budget package with the possible additional impact of sequestration may bring economic growth this year to a standstill.

The Commerce Department report was an economic warning. The drop in economic growth last year was largely an administrative anomaly, but it may be replaced with a real economic slowdown if we continue to cut federal spending. It remains to be seen if federal policymakers will listen.

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