Nothing grabs Washington’s attention quite like a sudden drop in the economy. When the U.S. Department of Commerce reported on Jan. 30 that the gross domestic product shrank at an annual rate of 0.1 percent in the fourth quarter—the first decline since the recession year of 2009—it reminded politicians that the economy is in no condition to withstand more confidence-damaging brinkmanship over spending and taxes. “This should be an alarm bell that it’s time to get to work on a compromise and an actual budget so we can at least take some of the fiscal uncertainty out of the economy,” says David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates in Toronto.
An alarm bell—as opposed to a raging blaze—is the right image. The economy is likely healthier than the GDP report suggests. Economists pointed out that the drop was caused largely by the sharpest reduction in defense spending in 40 years—which isn’t likely to happen again—and by smaller-than-normal growth in inventories, which will be reversed as shelves are stocked in the months ahead. Exports, which were weak, are also likely to rebound. The Federal Reserve’s rate-setting committee attributed the “pause” in growth to “weather-related disruptions and other transitory factors.”
Of course, “transitory factors” influence almost every quarter. What’s worrisome is that the underlying growth of the economy is so weak that a random fluctuation was enough to push it into negative territory. “We have a slowing economy on our hands at a time when aggregate growth is already at microscopic levels,” Rosenberg wrote to clients.
The economy will soon face another bout of politically induced trauma. Automatic, across-the-board cuts are set to take effect March 1 unless Congress acts; legislation that keeps the government operating for the current fiscal year expires March 27; and the debt-ceiling problem hasn’t gone away. Under the deal that temporarily suspended the debt limit, the ceiling will probably be reached again in August, the Bipartisan Policy Center estimated Jan. 30.
Even though the GDP decline reminded Washington of what’s at stake, don’t expect it to produce a new era of bipartisan comity. Republicans and Democrats immediately went to work spinning the quarterly data to support their narratives of what ails America. Kevin Hassett, the director of economic policy studies at the American Enterprise Institute and a 2012 Mitt Romney adviser, says “horrifying” fiscal and monetary policy is the economy’s basic problem. “Everything’s wrong, and money is on the sidelines,” he says. “The financial sector is tightly controlled by the Fed. There’s rent control for the bond market and massive deficits that crowd out private activity.” Douglas Holtz-Eakin, president of the American Action Forum and an adviser to John McCain’s 2008 presidential campaign, says the economy’s persistent slow growth is evidence that more stimulus won’t work. “We do need to move away from the notion that we’ve got a cyclical problem that can be solved with countercyclical spending policies,” he says. “We’ve played that card.”
But today’s budget deficits are largely cyclical. They would be much smaller if economic growth were stronger, generating more tax revenue. Liberal Democrats draw a conclusion that’s the opposite of Holtz-Eakin’s. Dean Baker, co-director of the Center for Economic Policy & Research, says trying to shrink budget deficits in the short term, with the economy weak, is “totally wrongheaded.”
As long as the two sides remain deadlocked, some kind of sequestration on March 1 looks likely. Cuts to both defense and nondefense spending might weaken growth in the second and third quarters by roughly one percentage point, Hassett calculates. Yet many House Republicans would choose that economic and political pain over a deal with President Obama that would increase taxes. “We would rather take some cuts in areas that we are not comfortable with than have no cuts at all,” says Republican Representative John Fleming of Louisiana.
Democrats see little political benefit in accepting Republican offers to forestall the sequester in exchange for cuts to entitlement programs such as Medicare. Alan Krueger, chairman of Obama’s Council of Economic Advisers, said in an e-mail statement that the automatic spending cuts would be “self-inflicted wounds to the economy.”
Worries over the stalemate in Washington appear to be sapping the confidence of businesses and consumers. The Thomson Reuters/University of Michigan survey of consumer sentiment fell in January to its lowest level since December 2011, with a record 25 percent of consumers citing the possibility of higher taxes. Though investment grew in the fourth quarter, in December the Duke University/CFO Magazine Global Business Outlook quarterly survey found that finance executives were throttling back growth plans for fear of damage from the fiscal cliff.
Even the positives in the Commerce Department’s quarterly report on the economy weren’t so positive: About half of the surprisingly strong 7.9 percent rate of increase in personal income was caused by a fluky 85 percent annual surge in dividend income, notes Michael Feroli, chief U.S. economist at JPMorgan Chase (JPM). Companies paid out extra dividends at the end of 2012 ahead of the anticipated tax increases.
Expect more of that kind of distortion of economic activity if Washington continues to lurch from one self-induced crisis to another. “Someone has to give up on ‘my way or the highway,’ ” says Holtz-Eakin. Obama has “thrown down the gauntlet” instead of negotiating, while Republicans “need to be mindful that they control a minority of the government,” he says. Washington had better figure out something soon. It’s not clear how much more of a beating this economy can take.