House Spending Cuts Will Hurt Economic Growth
Earlier this week, I voiced concern that the proposed spending cuts coming from the U.S. House of Representatives would threaten West Virginia's ability to meet important needs like education, environmental protection, and community development, while threatening the fragile economic recovery. Now a report prepared for Goldman Sachs confirms that the proposed spending cuts would hurt the economy, cutting growth by about two percent of GDP.
- Proposals to cut federal spending, the possibility of a government shutdown, and the escalated debate over state employee compensation has increased interest in the effect of fiscal policy on growth, after last year's fiscal package briefly neutralized the expected drag from federal fiscal policy.
- Federal spending cuts deserve the most attention. They are the most likely of these issues to occur, and could have the largest magnitude. The assumption we incorporated into our recently revised budget estimates—discretionary spending cuts of $25bn and $50bn below the CBO baseline for FY2011 and FY2012 respectively—would shave nearly one percentage point off of the annualized rate of real GDP growth in Q2, but would fade quickly with a negligible effect on growth by year-end.
- The related risk of a temporary federal government shutdown could also lead to a fiscal drag on growth, but this appears to be a lower probability scenario. We estimate that each week that the federal government is shut down would reduce federal spending by around $8bn, and could reduce real GDP growth by as much as 0.8 pp at an annualized rate in the quarter it occurred, but would provide a lift to growth in the following quarter as federal activity returned to the previous level.
- The policies that several state governments are debating related to state employee compensation and organization appear to have—at least in the short term—little potential macroeconomic effect. We assume that state governments will cut spending or raise taxes no more than necessary to balance their budgets. This amount will be determined by the level of tax receipts available to pay for spending, not political negotiations.
Fiscal drag is quickly reemerging as a focus, only a couple of months after an agreement to extend tax cuts and unemployment benefits appeared to have neutralized most of the drag from federal fiscal policy for most of 2011. We see federal spending cuts as the most important near-term risk. The possibility of a government shutdown is a significant but less likely factor, while the debate over state employee compensation seems unlikely to have a meaningful near-term macroeconomic effect:
Federal spending cuts would result in additional fiscal drag: In our recently updated budget deficit estimates, we have assumed that Congress will reduce discretionary spending by $25bn below the Congressional Budget Office's (CBO) baseline for FY2011, and another $25bn (for a total of $50bn below the baseline) for FY2012 (for more on these assumptions and our budget estimates, see "The US Budget Outlook: Better, but Not Good Enough," US Economics Analyst 11/05, February 4, 2011). By contrast, the House of Representatives passed legislation over the weekend to cut spending for FY2011 by $60bn from current levels (the House hasn't yet addressed FY2012). Both scenarios would add to the drag from federal fiscal policy on growth:
- The modest spending cuts we assume in our own budget forecast would lead to renewed fiscal drag. Since spending cuts could be enacted no earlier than next month, when the current fiscal year will be nearly half over, $25bn in cuts would require spending in the second half of FY2011 to be reduced by $50bn at an annual rate. Since the cut would be phased in abruptly, it could result in a drag on growth in Q2 by as much as one percentage point (pp), but would quickly fade over the next two quarters as spending stabilizes at a lower level, with little effect versus current policy on the rate of real GDP growth by year end.
- The spending cut package that passed the House of Representatives would have a deeper effect. Under the House passed spending bill, the drag on GDP growth from federal fiscal policy would increase by 1.5pp to 2pp in Q2 and Q3 compared with current law. However, we don't see this scenario as likely; while we expect discretionary spending to be cut, the current House proposal doesn't appear viable in the Senate, and the president has already threatened a veto.
A federal shutdown poses less risk, as long as it is brief: A federal shutdown can potentially occur when one or more of the 12 annual appropriations bills have not been enacted for the current fiscal year. Usually, Congress provides temporary funding through a "continuing resolution" (CR) until appropriations have been enacted, but from time to time, particularly when control of government is divided, this does not happen and funding lapses. When this occurs, any agency or cabinet department without funding in place for the current fiscal year must cease non-essential operations. So far, Congress has not enacted any of the annual appropriations bills for the fiscal year that began October 1, so a shutdown would affect virtually all non-essential programs. That said, the potential for a federal shutdown probably does not present a major risk:
- While the possibility of a shutdow n is real, it isn't that likely. We wrote more extensively on the key fiscal developments over the next few months last week (see "The Federal Budget Process Gets Underway," US Daily, February 17, 2011). The bottom line is that while rhetoric has escalated regarding spending cuts and the threat of a shutdown, we expect both sides to try to avoid one if possible, with the most likely solution appearing to be a short-term extension of funding at slightly reduced levels.
- The effect of a shutdown is narrower than the term implies. Even in the most protracted government shutdown to date, from November 13 to 19, 1995 and again from December 15, 1995 to January 6, 1996, the majority of federal employees kept working. In the first episode in November 1995, about 40% of federal employees excluding the postal service were furloughed; in the December lapse the share of furloughed employees dropped to less than 15%, since Congress had managed to enact some appropriations legislation between the two shutdowns. If a shutdown occurred next month, it would probably affect nearly all agencies and departments, since no appropriations legislation has been enacted so far this year. But even so, this would imply that only around 40% of federal employees would be affected.
- A shutdown lasting more than a week could be meaningful. If Congress fails to renew the continuing resolution that is set to expire on March 4, the lapse seems likely to be fairly short. After all, there have been several short government shutdowns over the last few decades, but only two lasting more than three days. But a lapse of more than a few days, particularly toward the end of the quarter, could be more important. If funding lapsed, non-essential services would shut down immediately, representing around $8bn per week in missed federal spending, assuming that 40% of federal employees (not including the postal service) and their activities are deemed non-essential. This would equate to $32bn in annualized terms, or around 0.2% of GDP for each week of shutdown. Pulling this spending out of Q2 would reduce the contribution to quarterly GDP growth from federal activity by a little over 0.8pp at an annualized rate for each week the shutdown lasted, though if the shutdown ended long enough before the end of the quarter it is quite possible that some of the missed activity could be made up, reducing the overall hit to growth. Otherwise, the return to previous spending levels following a one-week shutdown would actually increase growth in the following quarter by 0.5pp and by smaller amounts in subsequent quarters until most of the effect is reversed.
State budget negotiations seem likely to have the least effect: Debate over state employee compensation and the related issue of collective bargaining and other organizational issues among state employee unions have begun to make headlines in a number of states—Wisconsin, Ohio, and Indiana are the latest. While these issues are important for the longer-run fiscal health of state and local governments, in the short-term their balanced budget requirements make revenue shortfalls the most important factor driving their fiscal stance over the coming fiscal year (for most states, this begins in July). Political decisions will determine how spending cuts are distributed, and will also determine the mix of tax hikes and spending cuts, but are much less likely to change the overall amount of tightening that will occur. So while we continue to expect around 0.5pp in drag this year from state and local fiscal retrenchment, recent developments don't seem likely to change this in either direction.