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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 [1] from the U.S. Bureau of Economic Analysis (BEA).  

Gross domestic product (GDP) dropped [1] by 0.1 percent during the 4th quarter of 2012, the first GDP contraction in three years [2]. While this would ordinarily seem an ominous sign for the health of the nation’s economic recovery, most economists and market-watchers [3] 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 [4] over the period from October to December, driven largely by a steep drop in Pentagon contract spending [5] (military pay remained fairly consistent).  In turn, this drop in defense contracts is directly attributable [5] 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 [2] (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 [6]

Aside from the direct impacts of government spending cuts, a $40 billion drop in business inventories subtracted [3] 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 [7] and the fiscal austerity-induced [8] economic slowdown [9] 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 [10] (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.