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No One Should Be Surprised By Disappointing Fourth Quarter GDP

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By Aaron Klein

The news that the U.S. economy contracted in the fourth quarter of last year came as quite a shock. Not a single one of the 24 economists surveyed by Dow Jones to develop the "consensus estimate" predicted an economic contraction. The Federal Reserve’s January Beige Book, which collected data through the end of the year from twelve different regions of the country, characterized, “the pace of [economic] growth as either modest or moderate.”

Of course, the economic consensus being wrong should come as no surprise. In September 2008, when the nation was in the midst of the worst recession in over 70 years, the Wall Street Journal’s survey of 50 economists expected growth of over 1%, and only 3 of the 50 forecast negative growth.

A Contracting Economy

Why was the consensus off again? To answer that we need to start with what turned the economy from a path of growth to contraction. Two main culprits stick out: A decrease in the growth of private inventories, and the sharp slowdown in government spending mainly at the federal level. Absent these two factors, the economy would have grown by 2.5%.

The growth hit from inventories can be seen in two ways. A positive interpretation is that a drawdown of current inventory levels may set the stage for stronger growth as businesses restock their shelves. A negative interpretation is that businesses are looking ahead and preparing for weaker future growth. It is important to note, however, that personal consumption remained strong in the fourth quarter, rising by 2.2% at an annual rate. Business investment also grew at a brisk pace, further suggesting underlying strength in the economy. When you consider that personal consumption and business investment account for more than two-thirds of GDP, it is even more remarkable that the economy contracted in the fourth quarter.

The other main culprit behind our shrinking economy was the sharp decrease in government spending. Government spending fell by 6.6% in the fourth quarter, with federal government spending falling by 15% (both figures are at an annual rate). State and local government spending fell by less than one percent. The decrease in federal government spending was predictable and self-inflicted. It came as a result of the economic brinksmanship that played out between the political parties in Washington over fiscal policy and the debt ceiling.

It's About Expectations

As a result of the first failed attempt for a grand bargain on deficit reduction, the federal government created a “Sword of Damocles” to hang over its own head in the form of a series of sharp cuts in government spending known in Washington as ”the sequester.” As my BPC colleague Steve Bell has pointed out, the sequester would lead to a sharp decrease in government spending, which would have a significant impact on the economy

President Obama and the Congress reached an agreement on taxes and delayed both the debt ceiling and sequester. Shouldn’t that have removed the threat for now?

The answer to these questions has to do with the role of expectations. Economics has a long history of examining not only what is happening but how expectations of what will happen in the future shape current behavior. The most successful part of this research shows that future expectations of inflation have a profound influence on current inflation. This research was a main reason why the Federal Reserve under Chairman Paul Volcker successfully ended the period of high inflation in the 1970’s and early 1980’s and why future Fed Chairmen have been able to keep inflation contained.

Imagine that you are a mid-level government official with an annual budget of $100. You are prohibited by law from exceeding your budget. However, there is a good chance that at some point in the year your budget will be cut by around $10, though you are not sure when the cuts will happen. Facing that kind of uncertainty, as a responsible manager of money, you would spend a lot less at the beginning of the year to make sure to have enough in reserve to be prepared for the cuts you think are coming. Maybe you keep closer to $15 or $20 in reserve, just in case the cuts are larger, which is a real possibility, as the penalty is severe for going over budget (the federal law governing this carries harsh penalties). So you spend as little as possible until you know more about whether the cuts will happen and how large they will be.

The Federal Government’s budget runs from October 1 to September 30, meaning that the fourth quarter of 2012 is the government’s first quarter of fiscal year 2013. Federal spending in that quarter fell by over 15%, in-line with our thought experiment from above.

Careless Spending

One final observation about the practical effects of trying to run a government under the uncertainty of the sequester, where big budget decisions are postponed for two months at a time. Under the federal government’s budget rules, almost all government agency funds are appropriated on an annual basis. This means that any money that isn’t spent by the end of the fiscal year in September is taken from the office or agency that originally received it.

Thus, imagine that you are the responsible government manager described above and you suddenly learn that you can now spend that $15 or $20 that you’ve been saving. However, the catch is that you must spend that saved money extremely quickly (before October 1st) or you will forfeit it. Will you be able to spend it wisely, in accordance with your office’s annual budget and long-term priorities? Or will you just be in a race to use it before you lose it.

Forcing government agencies that have already tightened their belts to choose between spending money that may be impossible to get back or rush to spend funding regardless of need encourages these officials to make poor spending decisions, which no one wants. This is yet another cost of doing business by just kicking the can down the road.

Aaron Klein is the director of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative. Previously, Klein served at the Treasury Department as the deputy assistant for economic policy, policy coordination.