“Best-Looking GDP Drop Ever” Overshadowed by Approaching Sequester Fiasco in Washington


By: Alexander J. Miachika

On Wednesday, Jan. 30th, U.S. markets were greeted by the report of a surprise drop in GDP to end the 4th quarter of 2012.  One might have expected this to be a harbinger of doom–the start of a dive back into the depths of recession we thought we had just escaped–considering that unemployment continues to hover at 7.8%.  Instead, economist Paul Ashworth quickly pointed out that, despite a “one-off” drop in government spending, this was “the best-looking contraction in U.S. GDP you’ll ever see.”

The unexpected drop was largely caused by the biggest defense spending cuts in 40 years (22%) and slower inventory growth among businesses.  However, the economy’s core drivers of growth–consumer spending, business investment, and housing—remained stronger.  Consumer spending rose by 1.5 percent and residential construction rose by 15.3 percent.  Therefore, if not for those “one-time” cuts in government spending, the economy would have actually grown at a 2.6 percent annual rate. Furthermore, since Ashworth sees these private sector trends accelerating, the prospect of 2008 all over again is not a danger from a secular economic perspective.  This sentiment was also echoed–more importantly–by the markets, which closed down only marginally on that day (44 pts on the Dow).  Jim Paulsen, Chief Market Strategist at Wells Capital Management, explained, “I don’t think this negative number [(4th quarter GDP)] is going to have much legs.”  Unfortunately, despite the silver-lining to this figure, it is also a troubling reminder of what might happen if Congress and the White House fail to come to an agreement on spending before sequestration begins to take effect on March 1.

Sequestration is the $1.2 trillion across-the-board spending cuts (excluding Social Security, Medicaid, military pay, and veteran benefits) that will automatically kick in, if Congress fails to identify cuts on its own.  The White House and Senate agreed to this measure as part of the Budget Control Act of 2011 to convince House Republicans to agree to increase the debt ceiling that year.  In concert with raising the debt ceiling (since failure to do so would have been catastrophic), all parties compromised on a plan to cut projected spending in future years by an amount roughly roughly offsetting the increase in the debt ceiling.  While this solution would in no way lead to an elimination of current or future budget deficits, let alone a complete reversal of the accumulation of national debt, the compromise was projected to at least slow down the rise in national debt from its current trajectory.

The purpose of the sequester mechanism, was to be so draconian and unappealing to both sides that there would be a sufficient incentive to produce a long-term solution before the end of 2011.  Despite these drastic “incentives”, that obviously did not occur.  In fact, the sequester issue arose again, during the most recent fiscal crisis (the Fiscal Cliff), and Congress once again punted on it, extending the deadline to March 1 of this year.  Now it is almost time for Congress to grapple with the issue again, except this time it appears as if sequestration is actually going to happen.  The anticipated cuts to defense spending under sequestration are substantial, equaling more than half a trillion dollars over ten years.  Considering the effect that the 4th quarter drop in defense spending had on GDP, the question begs asking: will sequestration plunge the United States back into a recession?

If sequester cuts take effect in full, the answer is: maybe not, but it will still hurt.   Bank of America Merrill Lynch economist, Ethan Harris, predicts that a full sequester would cut 1% from 2013 GDP.  However, more optimistic experts believe the figure is closer to 0.5%.  Since some analysts  expect around 2% GDP growth again this year, sequestration would mean anemic growth of closer to 1%.  That would not leave much room for additional headwinds that will also be faced (read: increased taxes).  Additionally, some economists estimate it could eliminate almost 1 million jobs nationwide through 2014, with a large chunk of those losses coming from the Pentagon and defense contractors concentrated near the Virginia-D.C. area.  Considering the plodding rate of job creation since the recession officially ended, it will take a long time to reabsorb so many layoffs into the job market, unless it is offset by big gains in other sectors of the economy.  With the recent upbeat fundamentals in the private sector (excluding defense obviously), such a one-time shock could potentially coincide with positive offsets that will make up for it.  However, that does little to soften the blow for those people suddenly laid off in defense and government contracting.

Considering these costs to society, what is the most likely course of action that Congress will take?  Goldman Sachs believes that of all the tools available for bargaining leverage this spring, sequester is one that will be allowed to take effect to some extent.  While a failure to raise the debt ceiling would have very severe consequences that would hit immediately, sequestration is less of a “cliff” and more of a “slope”, unfolding over time with a lagging effect on the economy.  This means that Congress can allow the deadline to pass without the effects being felt immediately, as opposed to if Congress failed to raise the debt ceiling.  Indeed, Goldman expects that even if sequestration happens, it is still likely that Congress would eventually negotiate to eliminate some, but not all, of the cuts from happening in 2013. Congress may even kick the can down the road again to the end of the fiscal year in October, to find targeted cuts, and avoid the indiscriminate cuts that would kick in otherwise.

Looking at Congress’s track record of buying itself more time, instead of resolving these issues, it may be that Washington’s sequel-to-the-sequel of the first fiscal crisis is actually just another installment of a new recurring annual tradition for pundits to fixate over.  Although sequester was initially hugely unpopular, making the actual cuts to meet the demands of the Budget Act seems to be even less appealing, so  where is the incentive to stop delaying making these tough decisions?  Considering that markets continue to hover at recent highs in the face of all this uncertainty, those outside Washington appear to be wise to these tactics.  Sean West, an analyst with Eurasia Group, said, “I’d be surprised if the 113th Congress does much more than justify pushing off this year’s sequester with a small batch of cuts that take place over many years.”

Unfortunately, while markets may take Congress’s style of problem solving in stride, contractors and others dependent on the government’s spending appropriations cannot; the uncertainty will continue to make it difficult for these groups to budget for new projects and retain or hire new employees.  The drama may make for “riveting” 24-hour punditry, but the costs borne by stakeholders (that are not members of Congress or the President) make Congress’s modus operandi look irresponsible, considering what little progress they’re expected to make from all the air being blown.  Even if the U.S. does not slide back into a recession from all of this, indeed it’s looking like there’s a better than even chance it will continue to grow (albeit slowly), the costs to society in the form of hesitation by employers to hire and the still spiraling national debt are inexcusable.


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Fordham Journal of Corporate & Financial Law