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Fiscal Contraction Is Shrinking the U.S. Economy

House Speaker John Boehner (R-OH)

SOURCE: AP/J. Scott Applewhite

Speaker of the House John Boehner (R-OH) talks to reporters after a long closed-door meeting on a strategy to deal with a potential debt crisis, at the Capitol in Washington, Tuesday, January 22, 2013.

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Today’s release of U.S. economic growth numbers from the Bureau of Economic Analysis show the toll that the political conflict over the nation’s fiscal policy is taking on the economy. The U.S. economy contracted by 0.1 percent in the last quarter of 2012, putting the United States on the precipice of recession. The economy most certainly would have grown at a faster rate were it not for the ongoing political brinksmanship over the debt ceiling and the risk of sharp fiscal contraction in the form of the pending automatic “sequestration” budget cuts.

That feared contraction is now unfolding with the automatic across-the-board spending cuts due to go into effect on March 1. And we know what will happen if policymakers don’t work to scrap the so-called sequester: Economic growth and job creation this year and in the future will be slower than it needs to be. The “advance estimate” of the economic growth numbers we see today is often revised up slightly in the following months as better information becomes available. Nonetheless today’s shocking economic shrinkage should serve as a wake-up call for politicians to get off the fiscal contraction path and on a path that secures the recovery and lays a foundation of public investments for long-term economic growth.

The nation’s gross domestic product, or GDP—the sum total of goods and services produced by workers and capital in the United States—continued growing but at a slowing pace as 2012 drew to a close. The growth rate slowed 3.1 percent from the previous quarter and registered the first negative growth since June 2009. We can better understand how different parts of the economy are faring by looking at GDP’s constituent parts: consumption by households; investments in productive equipment and housing; exports and imports; and the government’s fiscal policy. For the economy to grow overall, all of these parts of the economy must grow in net.

Household consumption grew by 2.2 percent in the fourth quarter of 2012 after adjusting for inflation and, on a per capita basis, is up 1.3 percent over the previous year. This recent growth, however, belies the underlying structural constraints on consumption acceleration needed to support an overall growth revival. These constraints include America’s yawning income inequality as well as losses to household wealth from the bursting real estate bubble, financial crisis, and recession. Though personal incomes and consumption grew in the fourth quarter, this uptick was driven primarily by “a sharp acceleration in personal dividend income, an upturn in personal interest income,” according to the Bureau of Economic Analysis. Wages and salaries grew overall as well, but grew mainly from accelerated payments of salary bonuses in anticipation of tax changes to high-income individuals.

Income from salary bonuses and capital gains, however, are earned only by a relatively few very high-income and wealthy individuals in the United States. But down the ladder, many U.S. households have lost substantial wealth, including wealth tied to their homes, in the years since the Great Recession. These households will continue to need to save a larger portion of their incomes to rebuild savings and pay down debts. There is evidence that they’re doing exactly that as the average household saving rate climbed to 4.7 percent from 3.6 percent in the third quarter of 2012.

Today’s investment data from the Bureau of Economic Analysis provide some signs that the nation’s housing market—the cause of so many of the financial woes in the housing sector—is stabilizing. Investment in residential structures—new construction and the rehab of houses and multiunit homes—grew by 15.3 percent in the fourth quarter. Separate releases from the U.S. Census earlier this month also show home ownership rates stabilizing and vacancy rates declining in the last quarter. Investments in the productive equipment and software capital—things such as machinery and computers—also showed strong growth of 12.4 percent in the quarter.

There are two factors now holding back the U.S. economy that can be seen in today’s data release. First is the substantial uncertainty over U.S. fiscal policy created by political brinkmanship over the debt ceiling and the risks of fiscal contractions that are undermining the nation’s economic recovery. Here in the United States, the ongoing political fiscal policy conflict is fueling uncertainty in expectations of future consumption and investment in the economy. As a result businesses depleted and did not replenish their inventories as quickly in the fourth quarter of 2012—inventory adjustments shaved 1.3 percentage points off of growth. The forecasting firm Macroeconomic Advisers estimates such uncertainty is costing America’s annual economic growth rate 0.7 percentage points.

Beyond uncertainty over fiscal policy, public expenditures at all levels of government are actually already contracting. Government expenditures overall shrank by 15 percent in the quarter, led largely by defense demobilization, and the slow-bleed from state and local governments continued as their aggregate expenditures shrank 0.7 percent. A separate analysis from the Center for American Progress shows that fiscal policy changes since January of this year, and the prospect of more fiscal contraction in the near term from sequestered spending cuts of $85 billion in 2013, could slow the U.S. economic growth rate by another 1.9 percentage points.

The second factor is related to the failed hopes of other nations that bet on fiscal contraction policies hoping these austerity policies would somehow defy economic gravity and revitalize their economies. This pertains most importantly to a number of major economies in Europe, many of which are now entering double-dip recession, and in the case of England, a triple-dip recession. As growth slowed around the world, U.S. exports in the fourth quarter shrank by 5.7 percent. The growth slowdown in the United States and falling oil prices worldwide also decreased imports by 3.2 percent—as such, the net balance of U.S. trade moved more into deficit.

This outcome for economic growth was, unfortunately, predictable. In September 2011 the Obama administration foresaw that the U.S. economy had not yet reached sustainable recovery and proposed the American Jobs Act, which would have added an estimated 1.9 million jobs through investments in infrastructure, schools, and spending on first responders. The measure, however, was ultimately blocked by conservatives in Congress who have pushed relentlessly for drastic public spending cuts.

The threat of fiscal contraction that we now face is not only a threat to economic recovery today and long-term economic growth for the United States, but is economically unnecessary. As John Makin and Daniel Hanson, economists at the American Enterprise Institute, write: “An abrupt spending sequester … could cause a US recession, coming as it does on top of tax increases worth about 1.5 per cent of GDP enacted in January. … deficits have been, and will continue to be for some time, eminently sustainable.”

Congress, in other words, has no reason not to act. It is its—and many of our trading partners’—misguided push for fiscal contraction that now stands in the way of stronger U.S. economic growth.

Adam Hersh is an Economist with the Economic Policy team at the Center for American Progress.

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