Another Recession?

After coming out of a brutal recession in the 2008-09 period, is the economy slowing to the point of actually moving backward? GDP, which needs to expand by at least 3 percent to decently create jobs, slowed to 0.4 percent in the first quarter and 1.3 percent in the second quarter. The latest debt ceiling deal implies a slight cut to government spending for 2012 and potentially a large cut in 2013. The long-term impact of lower government spending can be very positive for the economy. It can unleash consumer and business confidence to get the economy rolling. However, in the very short term the macroeconomic impacts from the cuts to government spending will dent economic recovery. Less money spent building bridges or on defense means fewer workers receiving checks that can be spent at local shopping centers. The multiplier impact further hurts the shop owners to pull back their spending, and so on.

Government spending cuts will, therefore, shave a few decimal points of GDP growth in 2012 and 2013. The proposed federal spending cuts of $36 billion will chop off 0.2 percent to growth in 2012. If the specially set-up joint committee cannot come up with a better solution, then another larger government spending cut automatically gets enacted in 2013, which will likely reduce GDP by 0.5 to 0.8 percent. In addition to the federal government spending cuts, many of the local and state governments are also making their cuts, as imposed by the local and state balanced budget rules.

Economic courses teach that the government is only one smaller component of the economy. Consumers, businesses, and international trade make up the remainder. In equation form,

GDP = C + I + G + NX

C = consumer spending
I = business investment
G = government spending
NX = net export = export – import

G will be negative as said above. NX looks to be neutral. Even though exports are rising strongly, so are imports. C will be weakly positive because of high unemployment rate, weak wage growth, and the desire to save more by households. The net impact of these components implies essentially no growth to GDP.

Only business spending (the I component in the equation) is the power broker. Businesses have plenty of cash sitting idle. Some have said the vilification of millionaires and billionaires must stop to boost business confidence. Others have said big profits should be made to flow down to workers or taxed so that workers have more to spend. But one thing is clear - Businesses have the capacity to greatly increase spending and push the economy out of the doldrums. Therefore, how businesses spend will largely determine the trajectory of the broader economy. My best guess at the moment is that there will be some moderate boost in business spending due to this year’s special tax incentives (such as a 100% one-year depreciation allowance rather than a 15 year schedule). We will avoid another recession. However, GDP growth will only be around 1.5 to 2.5 percent this and next year. Such an expansion means only 1 to 2 million jobs created per year, and not the 3 to 4 million annual job gains needed to truly get us back to normal.