Fiscal Fiasco Looms

The threat of a budget and spending war breaking out in Washington represents a very real but unprecedented risk for the economy from the fiscal side that the Federal Reserve pointed out in Wednesday’s press conference. In the words of my friend and political strategist, Greg Valliere, rebellious House Republicans moved “closer to a government shutdown and debt crisis… that even {Republican political strategist} Karl Rove argues could do great damage to the Republican Party.” This is to nothing say of the damage that it would do to financial markets and the broader economy.

Valliere and a growing number of political handicappers I follow speculate that the chance of a full government shutdown is at least 50%. Worse yet, the tensions surrounding an increase in the debt ceiling are building. Adding insult to injury, social security checks would be among the first items to be affected if Congress fails to raise the debt ceiling and avoid an all-out default on our obligations to ourselves, and to investors the world over who bought into the “full faith and credit” of the United States.

The economic consequences of a fiscal crisis of this magnitude are so great that I can only try to gauge the hit to growth by looking at the last time we had to endure a government shutdown, in late 1995. The biggest problem is that those who want the shutdown most this time have the least incentive to make a deal. The Speaker of the House, John Boehner, has admitted as much by airing his frustration with his colleagues in recent days.

In late 1995, the government closed for five days in November and again from mid December to early January 1996. If this happens again, all government employees are vulnerable to furloughs (forced, unpaid leave). Essential workers in national security, public health and safety, including air traffic control workers, may be forced to work without pay. That would mean a hit to employment and income as we approach the critical holiday season. Social security and other transfer checks were also delayed 18 years ago, as those few left in government offices to work without pay couldn’t process the volume necessary to cut the checks. If you are trying to get a passport, get it done soon because that is another service likely to be shut down.

In total, some 800,000 workers were affected in November 1995; almost 300,000 were furloughed, while 500,000 worked without pay. Agreements with private contractors were suspended, and even economic data was put on hold. The much-watched, monthly employment report would likely be delayed if a shutdown were to occur, putting me and other economists effectively on furlough.

In response, back then everything from consumer spending to business investment slowed; inventories were stockpiled and government spending contracted; nondefense government spending plummeted at a double-digit pace; real GDP growth decelerated by 0.6% in the fourth quarter of 1995 to a 2.9% pace, down from a 3.5% pace in the third quarter.

Bottom Line: The economy has already decelerated from a 2.5% pace in the second quarter of this year to an estimated 1.8% pace in the third quarter. Do we want to risk stall speed again in the fourth quarter just because our elected officials can’t bring themselves to negotiate on our behalf? Incompetence is a cost that cumulates over time.

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