Contraction Reaction

by Benjamin Studebaker

The United States has just now posted the worst quarterly growth figures since 2009. The United Kingdom, the country in which I study, is also experiencing economic contraction again, in what may be the start of a triple dip recession in that country. What’s going on? Let’s have a look.

First, let’s look at the numbers in context. Here’s US GDP growth since Obama took office in January 2009:

And here’s UK GDP growth since the coalition government displaced labour in May 2010:

In the British case, the cause of contraction is fairly obvious–austerity has been the British government’s hallmark, countered only by the Olympics (the effect of which buoyed the previous quarter but has now tapered off) and quantitative easing by the Bank of England. The IMF lays the blame squarely on Britain’s austerity policies in its recent report. Indeed, in back to back years, Britain has enacted austerity that cut state spending by 1.5 and 1.6% of GDP, respectively. The IMF estimates that spending cuts during touch economic times carry a multiplier of 1.5–meaning that, for every 1% reduction in state spending, 1.5% of GDP growth is lost. By that estimate, Britain lost 2.25 and 2.4% of its potential growth in 2011 and 2012, respectively, to spending cuts.

The American case is more interesting, given its defiance of many quarters of seemingly upward trend. What is going on in the states? Well, despite our aversion of much of the spending cuts and tax increases that were scheduled to happen after the fiscal cliff, a few smaller items managed to slip through. By themselves, each seems fairly innocuous, but taken together and you have a fairly substantial American austerity package in the works for 2013. Brad Plumer points out what’s still on the books:

This includes the expiration of the payroll tax cut, which will raise about $125 billion this year. It includes $50 billion in scheduled cuts to discretionary spending from the caps in the 2011 Budget Control Act, as well as $24 billion in new Obamacare taxes and $27 billion in new high-income taxes. It also includes about $78 billion from the now-delayed sequester cuts — assuming that these either take effect or are swapped with other cuts.

Plummer even includes a graph for handy reference to show the scale of what we are planning to do to ourselves relative to our fellow austerians:

Taken together, this amounts to $304 billion in austerity, or 1.9% in GDP during 2013–a larger cut over this year than Britain implemented in either 2011 or 2012. One might argue that the sequester cuts might be called off altogether without replacement. In that scenario, the cut is $226 billion, good for about 1.5%. If the IMF estimate for the multiplier is right (the IMF believes the multiplier during periods of economic weakness is larger than it is during normal times), the US could be looking at anywhere from 2.25% to 2.85% in lost growth over the course of the next year.

Of course, those cuts and tax hikes don’t kick in until 2013. They still do not explain why we had contraction this past quarter. To answer that, we need to look at the psychological climate the fiscal cliff provided, the expectations it introduced.

The largest part of the upcoming cuts relates to something that should directly influence the spending habits of every American who paid the least bit attention–the end of the payroll tax holiday. The end of the holiday imposes an additional $1,000 in tax on a person making $50,000 a year–it’s more for those who go beyond that. Hearing that their payroll taxes were set to rise, people may have been more reluctant to consume last quarter. This is perhaps a more specific example of a general principle; being nervous about the outcome of the fiscal cliff fight made people throughout the economy generally more cautious. This may sound like speculation, but we do have some quantitative means of measuring how people are feeling about things. While it’s not necessarily the case that the way people are feeling corresponds to reality (spending could be higher or lower than most people think it is), it is true that how people think the economy is doing has some influence on how the economy does. If we look at consumer confidence, we can see that people felt considerably more pessimistic about the economy during the last quarter:

The quarterly drop in confidence between the third quarter and the fourth quarter is 8 points large–the biggest quarterly drop since the debt ceiling fight in 2011. The debt ceiling period also produced the next worst quarter of growth since the recession formally ended (the 0.1% expansion in mid-2011). The pessimism that concerns over debt, deficits, spending cuts, and tax increases create can itself be economically destructive in so far as it encourages more saving and less spending or investing. I would even venture to say that some republicans, disappointed by Mitt Romney’s electoral defeat, may have begun squirrelling money away or rethinking planned spending or investing increases. Is that economically rational behaviour? No, but since when was all economic behaviour rational? “Animal spirits”, the beliefs and mood swings of economic actors as a group, have power. Because people need to spend in order for the economy to grow, anything that causes decreased spending, whether rational (like job losses, wage and benefit cuts, tight money, insufficient credit, etc.) or irrational (the bond vigilantes are coming, inflation is going to take off, the socialist bastard was re-elected) can have profound economic influences.

This means something going forward–if the government chooses not to reverse its spending cuts and tax increases, the contraction they cause will likely be further deepened by the negative public reaction to it. Given the government’s fixation on debt and deficits at the expense of growth and jobs (and yes, unemployment is a lagging indicator and will likely rise going forward if this continues), I hold out little hope for 2013. It is very likely to be Barack Obama’s 1937. What happened in 1937? Oh, yes, this:

Any marauding Japanese war machines out there to stir a preparatory spending boost in 2014?