Government spending cuts responsible for 4th quarter economic contraction

It turns out government spending is the problem with the economy—there’s been too little of it over the last few months, according to Wednesday’s report from the U.S. Bureau of Economic Analysis (BEA).  

Gross domestic product (GDP) dropped by 0.1 percent during the 4th quarter of 2012, the first GDP contraction in three years. While this would ordinarily seem an ominous sign for the health of the nation’s economic recovery, most economists and market-watchers have argued that the contraction is temporary and likely the result of government policy, rather than signs of a long-term downturn.   

Specifically, the fourth quarter contraction is due to sharp reductions in government spending on national defense contracts coupled with a $40 billion drop in business inventories resulting from the same policy environment.

Defense contracts are the most striking example of the negative economic consequences of cutting government spending in the midst of a sluggish recovery. In its most recent report, the BEA estimates that defense spending fell by a staggering 22 percent over the period from October to December, driven largely by a steep drop in Pentagon contract spending (military pay remained fairly consistent).  In turn, this drop in defense contracts is directly attributable to the winding down of two wars, and more importantly, the looming threat of sequestration, the $60 billion in automatic, across-the-board cuts to Pentagon programs originally scheduled to take effect this January, but were delayed until March 1 by the Fiscal Cliff bill. In the face of these looming cuts and the drawdown in American military operations overseas, these defense contractors sharply curtailed their purchasing and hiring over this period given the uncertainties around future Pentagon spending.

Taken together with other reductions in state and local government spending, this drop in defense expenditures knocked 1.33 percentage points off the total change in economic growth. As seen in the following graph (h/t Ezra Klein), if not for these spending reductions, the economy would have grown by 1.23 percentage points rather than shrunk by 0.1 percentage points, demonstrating once again that government spending has a positive impact on economic growth. Likewise, cutting government spending can often harm economic growth.

 4th Quarter 2012 GDP

Aside from the direct impacts of government spending cuts, a $40 billion drop in business inventories subtracted another 1.25 percentage points from GDP growth. This means that businesses largely focused on selling the goods already on their shelves, rather than expanding new production, despite strong consumer and business spending. Much of this is likely due to policy uncertainties related to the fiscal cliff and the fiscal austerity-induced economic slowdown in European markets. In both cases, concerns over the possibility of significant government spending cuts in the United States and the reality of existing spending cuts in Europe contributed directly to a slowdown in American business expansion.

By the numbers, it’s clear that reductions in government spending are dragging down economic growth. And they’re doing so at a time when negative interest rates (in which investors are actually paying the federal government to borrow money) make it cheaper than ever to finance key federal investments in economic growth—education, workforce training, infrastructure, and workforce training.

So, yes, government spending—specifically government spending cuts—are the problem, having produced the first contraction in GDP since the end of the Great Recession.

6 Comments

  1. Kevin

    February 1, 2013 at 11:40 am

    Obviously government spending props up the economy, does anyone really argue against that? The only thing is, aren’t we completely reliant on it, and won’t that only get worse as we go forward? If spending isn’t an issue, why don’t we just go for broke, print and borrow like mad, and just do whatever we want?

  2. Doug

    February 1, 2013 at 3:47 pm

    Kevin,
    Your suggestion is exactly what we are doing and why we have skyrocketed from ~$10 trillion to greater than $16 trillion in debt in the past five years. That, and not passing a budget and letting all the “stimulus” roll over every year.

    This print and spend scheme has not worked for Japan over the past 20 years, and it will not work here. The price of all this money in the system will be future inflation, and that will not be pretty either. This Bernake guy is really working hard with Obama and the Democrats to build a huge house of cards.

  3. david esmay

    February 1, 2013 at 5:03 pm

    Alex is using a new name today to have a conversation with himself. Government spending is used as an economic stimulus during recessions or slow periods of growth. The problem we have is that during the last Retardlican administration they reversed the equation and went on a tax cut and spending spree during a period of growth. Now the right suggests we do the opposite, cut spending at a time of slow growth and reduced revenue. The Costanza rule must be applied whenever a Retardlican proposes an economic idea, whatever they say, do the opposite and that will be the correct decision.

  4. Doug

    February 2, 2013 at 8:30 am

    david/joe/paul (Can you tell me why you think I am some Alex guy? Do you troll someone else too?),
    Once again you show your lack of knowledge of economics. The recession has ended, you can check with your messiah in the white house if you don’t believe me (earlier this week I remember seeing the Democraps in the news saying this was a great recovery). We have done the wrong thing with propping up the economy in the way we have and it will come back to bite us.

    What is holding our country back now is the debt and deficit spending. Are you really so ignorant you cannot see that we are closing in on borrowing as much in 8 years as the country had done over the previous 240 years. If you think this is a good thing then you deserve what you get.

  5. Alex

    February 2, 2013 at 10:49 am

    I wouldn’t worry much about esmay if I were you Doug. He’s totally delusional about me being several different people including you and some Frances Jenkins, and is strangely fixated on George Bush. To him, every economic problem can be traced back to the Bush era. I have referred him to many government charts on this runaway spending of the Obama years, and he is either unable to read them or refuses to believe the facts. He seems to be wrapped into a time warp back to the early 2000′s, and often repeats facts and figures that are totally obsolete.I’ve found the best solution is to simply ignore his strange ramblings, and his bizarre use of the English language.

  6. Doug

    February 2, 2013 at 11:03 am

    Thanks Alex. I am new to the site, but I guess I should have known to watch out for the tin foil hat folks trolling around.. this is a lib site after all.

    Queue up the “talking to himself” comment in 3…2…1….