Latest Data Show We Are Already On A Downslope Toward The Fiscal Cliff

by: Ed Dolan

These days the “fiscal cliff” dominates the discussion of U.S. budget policy. The cliff is the package of tax increases and spending cuts baked into current law that will come into effect at the end of the year if Congress does not act. What is less widely recognized is that the U.S. economy is already on a downslope. The latest GDP and jobs data show that a substantial amount of fiscal austerity is already in effect. A steadily shrinking government sector is slowing growth of jobs and output. To say that the economy may teeter over the cliff at the end of the year understates the problem. If nothing is done, we will hit the cliff at a jog. There is much that we should do before we get there, and time is running out.

According to a recently released CBO analysis, the potential austerity impact of the cliff would amount to more than 4 percent of GDP in calendar 2013, even taking automatic stabilizers into account. The CBO concludes that tax increases and expenditure cuts of that size would likely put the economy back into recession.

Aren’t we already in recession? No, not by the usual definition. Popular discourse has come to use “The Great Recession” to refer to the entire prolonged period of high unemployment and erratic growth that the economy has experienced since late 2007, but that is not how economists think of recession. They either use a shorthand definition under which a recession is a period of falling real GDP lasting six months or more, or else they defer to the Business Cycle Dating Committee of the National Bureau of Economic Research, which uses a more subjective approach that usually comes to much the same thing.

As this first chart shows, by the economist’s definition, the recession that began at the end of 2007 ended in June 2009. After that came a “recovery” phase of the cycle, which lasted until real GDP reached its previous peak in the third quarter of 2011. Since then, the economy has been in “expansion,” meaning that it is growing beyond its previous peak output. The trouble is that populaton, capital, and productivity have increased since 2007, raising potential real outuput–the normal level that would prevail when the economy is neither in a state of boom or bust. As a result, unemployment is still above its natural level. The exact levels of “potential GDP” and “natural unemployment” are matters of controversy, but almost everyone agrees we have not reached them yet.

Furthermore, the latest data seem to show that the expansion is slowing. Pending annual revisions due out in August, real GDP appears to have grown at a 3 percent annual rate in Q4 2011. The advance estimate for Q1 2012 showed a 2.2 percent rate of growth. The second estimate for Q1, released last week, was just 1.9 percent.

A reduction in the growth rate from the advance to the second estimate is not quite the same as a measured decrease in the rate of growth; technically, it is just a new estimate of the total growth for the whole quarter in question. For example, in Q4 2011, the second estimate was lower than the advance estimate, but the final estimate moved back up again. However, the data that go into the advance estimate are drawn more heavily from the first months of the quarter and more of the advance estimate is based on extrapolation of past trends. That means that a second estimate lower than the advance at least hints that the economy may have been slowing as the quarter went on. Almost the only significant counter-indication is the fact that Gross Domestic Income was reported to have grown at a 2.7 percent rate in Q1, faster than in Q4 and faster than Q1 GDP. In the long run GDP and GDI tend to grow at the same rate.

In this case, the impression that the economy is slowing is reinforced by a truly dismal jobs report released just two days after the GDP data. The number of nonfarm payroll jobs increased by just 69,000, the least in a year. Furthermore, the job increases for the previous two months were hit by sharp downward revisions. Payroll job gains in March turned out to be just 143,000 rather than 154,000, and 77,000 in April rather than 115,000. Those revisions are not true job losses, but they do mean that the gains in those months were 49,000 fewer than previously tallied. When we adjust the reported 69,000 jobs gained in May for the previous overstatements, it would be accurate to say that we now have only have 20,000 more payroll jobs than we thought we had a month ago.

Furthermore, the data from the household employment survey are not much more encouraging than those from the payroll jobs report. True, the household survey, which includes farm workers and self-employed persons, showed an increase of 422,000 jobs, and both the labor force participation rate and the employment-population ratios regained lost ground, all signs of an expanding economy. However, the headline unemployment rate increased from just under 8.1 to just over 8.2 percent, and U-6, the broad unemployment measure that includes marginally attached workers and those involuntarily working part time, rose from 14.5 to 14.8 percent. Also, the mean duration of unemployment increased, as did the percentage of unemployed who have been out of work for 27 weeks or longer.

What is driving the apparent slowdown? It would be comforting to be able to blame a faltering world economy and a strengthening dollar, but judging by the GDP numbers that does not seem to be the case. The following table shows the contributions of each sector to real GDP growth according to the advance and second estimates from the Bureau of Economic Analysis. Exports, which we would expect to show the effects of a slowing world economy, held up well in the first quarter. In fact, the second estimate showed them even stronger than did the advance estimate. The contribution of private investment also increased from the advance to the second estimate, although not by as much. Exports and investment, then, turn out to be the relatively good news, not the bad, in the latest GDP report.

Instead, the largest share of the decrease in estimated real GDP growth came from an accelerated shrinkage of the government sector. The negative .78 percentage point decrease of the government sector is the main indicator that we are already on the downward slope toward the fiscal cliff. More than half of the slowdown in government spending came from the defense department, but no category of government failed to shrink..

Downsizing the government, to be sure, is not a bad thing in itself. I am happy to see the defense department shrink as foreign military adventures wind down, and like anyone else, I have my pet list of subsidies, regulations, and boondoggles I would like to see the back of. However, shrinking government is not a plan for fiscal reform; it is only part of a plan.

Speaking Sunday morning to CNN’s Fareed Zakaria, Glenn Hubbard, influential economic adviser to GOP presidential candidate Mitt Romney, appeared to agree. What we need to do, Hubbard said, is put the federal budget on a glide path to sustainability over the next four years. At the same time, he said, there has been too much focus on immediate reduction of the current year’s budget deficit. Other elements of fiscal reform have to be implemented in a balanced manner.

Those other parts include reforming the tax system by eliminating tax expenditures and lowering marginal rates, fixing an unreasonably expensive medical establishment, and finding a way to keep the economy going in the short run while we make needed long-run structural changes. Running downhill toward a cliff is not a promising way to ensure that all the pieces of fiscal reform come together in the right way at the right time. With government spending already on a downward trajectory, there is a real risk that one part of the reform package will get far enough ahead of the others to do real harm.

The last time I blogged about shrinking government, I included a version of the following chart, which drew widespread disbelief because of its failure to show any “explosion of government spending” under the Obama administration. To avoid going over the same issues, let me explain more carefully this time just what the diagram shows and does not show:

  1. It shows an indicator called “government consumption expenditure and gross investment,” which is the appropriate measure of the contribution of the government sector to GDP.
  2. It includes federal, state, and local levels of government.
  3. It shows government spending as a percent of GDP to eliminate the effect of inflation.
  4. It does not include transfer payments, such as unemployment benefits, social security, and Medicare, which do not directly add to GDP.

When I explained those points in the course of a dialog with commenters, the message I got back was, “Oh, you’re cheating then. Government really is exploding. You just hid the fact by omitting transfer payments and making a phony adjustment for inflation.” Well, OK then, let’s see what has been happening to a different measure that avoids those objections—one called “government current expenditures.” This measure, shown in the next chart, includes transfer payments and shows absolute numbers, neither scaled as a percent of GDP nor adjusted for inflation.

Lo and behold, this measure has not “exploded” under the Obama administration, either! To be sure, it shows an upward trend through 2009 to 2011, when the GDP-related measure of government spending shown in the previous chart had already begun to fall. However, there is no explosive break in the upward trend at the time the White House changed hands. Furthermore, we see that nominal current expenditures peaked in the second quarter of 2011 and have fallen since. There was an increase of 0.3 percent in the first quarter of 2012, but even that small increase is less than the rate of inflation, and less than enough to bring government current expenditures back to their previous nominal peak.

Including transfer payments does raise one point that is of interest to the discussion of the impending fiscal cliff. It is true that transfer payments do not directly contribute to GDP, but they do contribute indirectly to the extent that they affect consumption behavior. As the tables above show, the apparent slowdown in growth from the advance to second estimates for Q1 GDP is due in part to a decrease in the contribution from consumption. That, in turn, may be partly caused by a squeeze on personal income from transfer payments, especially on the state and local level. Furthermore, some elements of the cliff itself consist of reductions in transfer payments, for example, extended unemployment benefits. If those come into effect, they will put further downward pressure on personal income and consumption. That is another element to consider when balancing the need for long-run downsizing of government against the short-term effects of fiscal austerity.

Finally, just to drive one last nail into the coffin of the exploding government hypothesis, here is another chart, this one showing the total number of government workers on federal, state, and local payrolls. The government workforce grew steadily throughout the Bush years. Setting aside the spike in temporary workers associated with the constitutionally mandated 2010 census, the number of government workers peaked in April, 2009, just as the first of the Obama administration’s fiscal policies were beginning to take effect. Since the census workers came off the payroll, the picture has been one of unabated decline.

The bottom line: We are already undergoing the first stages of austerity, American style. Falling government consumption and investment expenditures, falling current expenditures including transfer payments, and falling government employment are already undermining the weak expansion.

Accelerating the downsizing of government should, at this point, be the lowest priority among the needed elements of balanced fiscal reform. There is room to quibble as to whether Hubbard’s chosen glide path is exactly right. He wants to aim for federal spending equal to 20 percent of GDP by 2016; others argue for a somewhat higher or lower path. Still, fine-tuning the glide path is not the main issue at this point.

The highest priority should be to work out a package of tax reforms that combine growth-enhancing lower marginal tax rates with elimination of loopholes and tax expenditures. Again, there is disagreement as to whether those reforms should be revenue-neutral or should contribute to deficit reduction, but the basic concept of reform is widely accepted. Close behind that should come reforms of our health care system to cut its costs and raise its quality so that it at least approaches, if not matches, those of other rich countries. After that, there are wasteful and counterproductive energy and environmental policies waiting for action.

The one thing that is sure to bring unpleasant results is to do nothing. A grand bipartisan deal to extend the present fiscal mess for the new Congress to deal with is not a much better option. There is plenty to do and not much time to get started.