Ed Dolan's Econ Blog

Latest Data Show We Are Already on a Downslope Toward the Fiscal Cliff

These days the “fiscal cliff” dominates the discussion of U.S. budget policy. The cliff is the package of tax increases and spending cuts baked into current law that will come into effect at the end of the year if Congress does not act. What is less widely recognized is that the U.S. economy is already on a downslope. The latest GDP and jobs data show that a substantial amount of fiscal austerity is already in effect. A steadily shrinking government sector is slowing growth of jobs and output. To say that the economy may teeter over the cliff at the end of the year understates the problem. If nothing is done, we will hit the cliff at a jog. There is much that we should do before we get there, and time is running out.

According to a recently released CBO analysis, the potential austerity impact of the cliff would amount to more than 4 percent of GDP in calendar 2013, even taking automatic stabilizers into account. The CBO concludes that tax increases and expenditure cuts of that size would likely put the economy back into recession.

Aren’t we already in recession? No, not by the usual definition. Popular discourse has come to use “The Great Recession” to refer to the entire prolonged period of high unemployment and erratic growth that the economy has experienced since late 2007, but that is not how economists think of recession. They either use a shorthand definition under which a recession is a period of falling real GDP lasting six months or more, or else they defer to the Business Cycle Dating Committee of the National Bureau of Economic Research, which uses a more subjective approach that usually comes to much the same thing.

As this first chart shows, by the economist’s definition, the recession that began at the end of 2007 ended in June 2009. After that came a “recovery” phase of the cycle, which lasted until real GDP reached its previous peak in the third quarter of 2011. Since then, the economy has been in “expansion,” meaning that it is growing beyond its previous peak output. The trouble is that populaton, capital, and productivity have increased since 2007, raising potential real outuput–the normal level that would prevail when the economy is neither in a state of boom or bust. As a result, unemployment is still above its natural level. The exact levels of “potential GDP” and “natural unemployment” are matters of controversy, but almost everyone agrees we have not reached them yet.

Furthermore, the latest data seem to show that the expansion is slowing. Pending annual revisions due out in August, real GDP appears to have grown at a 3 percent annual rate in Q4 2011. The advance estimate for Q1 2012 showed a 2.2 percent rate of growth. The second estimate for Q1, released last week, was just 1.9 percent.

A reduction in the growth rate from the advance to the second estimate is not quite the same as a measured decrease in the rate of growth; technically, it is just a new estimate of the total growth for the whole quarter in question. For example, in Q4 2011, the second estimate was lower than the advance estimate, but the final estimate moved back up again. However, the data that go into the advance estimate are drawn more heavily from the first months of the quarter and more of the advance estimate is based on extrapolation of past trends. That means that a second estimate lower than the advance at least hints that the economy may have been slowing as the quarter went on. Almost the only significant counter-indication is the fact that Gross Domestic Income was reported to have grown at a 2.7 percent rate in Q1, faster than in Q4 and faster than Q1 GDP. In the long run GDP and GDI tend to grow at the same rate.

In this case, the impression that the economy is slowing is reinforced by a truly dismal jobs report released just two days after the GDP data. The number of nonfarm payroll jobs increased by just 69,000, the least in a year. Furthermore, the job increases for the previous two months were hit by sharp downward revisions. Payroll job gains in March turned out to be just 143,000 rather than 154,000, and 77,000 in April rather than 115,000. Those revisions are not true job losses, but they do mean that the gains in those months were 49,000 fewer than previously tallied. When we adjust the reported 69,000 jobs gained in May for the previous overstatements, it would be accurate to say that we now have only have 20,000 more payroll jobs than we thought we had a month ago.

Furthermore, the data from the household employment survey are not much more encouraging than those from the payroll jobs report. True, the household survey, which includes farm workers and self-employed persons, showed an increase of 422,000 jobs, and both the labor force participation rate and the employment-population ratios regained lost ground, all signs of an expanding economy. However, the headline unemployment rate increased from just under 8.1 to just over 8.2 percent, and U-6, the broad unemployment measure that includes marginally attached workers and those involuntarily working part time, rose from 14.5 to 14.8 percent. Also, the mean duration of unemployment increased, as did the percentage of unemployed who have been out of work for 27 weeks or longer.

What is driving the apparent slowdown? It would be comforting to be able to blame a faltering world economy and a strengthening dollar, but judging by the GDP numbers that does not seem to be the case. The following table shows the contributions of each sector to real GDP growth according to the advance and second estimates from the Bureau of Economic Analysis. Exports, which we would expect to show the effects of a slowing world economy, held up well in the first quarter. In fact, the second estimate showed them even stronger than did the advance estimate. The contribution of private investment also increased from the advance to the second estimate, although not by as much. Exports and investment, then, turn out to be the relatively good news, not the bad, in the latest GDP report.

Instead, the largest share of the decrease in estimated real GDP growth came from an accelerated shrinkage of the government sector. The negative .78 percentage point decrease of the government sector is the main indicator that we are already on the downward slope toward the fiscal cliff. More than half of the slowdown in government spending came from the defense department, but no category of government failed to shrink..

Downsizing the government, to be sure, is not a bad thing in itself. I am happy to see the defense department shrink as foreign military adventures wind down, and like anyone else, I have my pet list of subsidies, regulations, and boondoggles I would like to see the back of. However, shrinking government is not a plan for fiscal reform; it is only part of a plan.

Speaking Sunday morning to CNN’s Fareed Zakaria, Glenn Hubbard, influential economic adviser to GOP presidential candidate Mitt Romney, appeared to agree. What we need to do, Hubbard said, is put the federal budget on a glide path to sustainability over the next four years. At the same time, he said, there has been too much focus on immediate reduction of the current year’s budget deficit. Other elements of fiscal reform have to be implemented in a balanced manner.

Those other parts include reforming the tax system by eliminating tax expenditures and lowering marginal rates, fixing an unreasonably expensive medical establishment, and finding a way to keep the economy going in the short run while we make needed long-run structural changes. Running downhill toward a cliff is not a promising way to ensure that all the pieces of fiscal reform come together in the right way at the right time. With government spending already on a downward trajectory, there is a real risk that one part of the reform package will get far enough ahead of the others to do real harm.

The last time I blogged about shrinking government, I included a version of the following chart, which drew widespread disbelief because of its failure to show any “explosion of government spending” under the Obama administration. To avoid going over the same issues, let me explain more carefully this time just what the diagram shows and does not show:

  1. It shows an indicator called “government consumption expenditure and gross investment,” which is the appropriate measure of the contribution of the government sector to GDP.
  2. It includes federal, state, and local levels of government.
  3. It shows government spending as a percent of GDP to eliminate the effect of inflation.
  4. It does not include transfer payments, such as unemployment benefits, social security, and Medicare, which do not directly add to GDP.

When I explained those points in the course of a dialog with commenters, the message I got back was, “Oh, you’re cheating then. Government really is exploding. You just hid the fact by omitting transfer payments and making a phony adjustment for inflation.” Well, OK then, let’s see what has been happening to a different measure that avoids those objections—one called “government current expenditures.” This measure, shown in the next chart, includes transfer payments and shows absolute numbers, neither scaled as a percent of GDP nor adjusted for inflation.

Lo and behold, this measure has not “exploded” under the Obama administration, either! To be sure, it shows an upward trend through 2009 to 2011, when the GDP-related measure of government spending shown in the previous chart had already begun to fall. However, there is no explosive break in the upward trend at the time the White House changed hands. Furthermore, we see that nominal current expenditures peaked in the second quarter of 2011 and have fallen since. There was an increase of 0.3 percent in the first quarter of 2012, but even that small increase is less than the rate of inflation, and less than enough to bring government current expenditures back to their previous nominal peak.

Including transfer payments does raise one point that is of interest to the discussion of the impending fiscal cliff. It is true that transfer payments do not directly contribute to GDP, but they do contribute indirectly to the extent that they affect consumption behavior. As the tables above show, the apparent slowdown in growth from the advance to second estimates for Q1 GDP is due in part to a decrease in the contribution from consumption. That, in turn, may be partly caused by a squeeze on personal income from transfer payments, especially on the state and local level.  Furthermore, some elements of the cliff itself consist of reductions in transfer payments, for example, extended unemployment benefits. If those come into effect, they will put further downward pressure on personal income and consumption. That is another element to consider when balancing the need for long-run downsizing of government against the short-term effects of fiscal austerity.

Finally, just to drive one last nail into the coffin of the exploding government hypothesis, here is another chart, this one showing the total number of government workers on federal, state, and local payrolls. The government workforce grew steadily throughout the Bush years. Setting aside the spike in temporary workers associated with the constitutionally mandated 2010 census, the number of government workers peaked in April, 2009, just as the first of the Obama administration’s fiscal policies were beginning to take effect. Since the census workers came off the payroll, the picture has been one of unabated decline.

The bottom line: We are already undergoing the first stages of austerity, American style. Falling government consumption and investment expenditures, falling current expenditures including transfer payments, and falling government employment are already undermining the weak expansion.

Accelerating the downsizing of government should, at this point, be the lowest priority among the needed elements of balanced fiscal reform. There is room to quibble as to whether Hubbard’s chosen glide path is exactly right. He wants to aim for federal spending equal to 20 percent of GDP by 2016; others argue for a somewhat higher or lower path. Still, fine-tuning the glide path is not the main issue at this point.

The highest priority should be to work out a package of tax reforms that combine growth-enhancing lower marginal tax rates with elimination of loopholes and tax expenditures. Again, there is disagreement as to whether those reforms should be revenue-neutral or should contribute to deficit reduction, but the basic concept of reform is widely accepted. Close behind that should come reforms of our health care system to cut its costs and raise its quality so that it at least approaches, if not matches, those of other rich countries. After that, there are wasteful and counterproductive energy and environmental policies waiting for action.

The one thing that is sure to bring unpleasant results is to do nothing. A grand bipartisan deal to extend the present fiscal mess for the new Congress to deal with is not a much better option. There is plenty to do and not much time to get started.

20 Responses to “Latest Data Show We Are Already on a Downslope Toward the Fiscal Cliff”

Fernando BetancorJune 4th, 2012 at 11:14 am

Dear Mr. Dolan,

Excellent analysis, but you leave out the vast austerity that has been underway since 2008 at the state and local government levels. These have been negative in every quarter since 3Q08 except for three, for a total fall (peak to trough) of -6.6% in real terms. This explains, at least partially, why the ARA stimulus package was less successful than it might have been: it was almost wholly counteracted by the fall in state expenditures. The pro-cyclical nature of state balanced budget requirements ensures that this effect will be repeated in every downturn, requiring an even larger, but politically more difficult, Federal stimulus.

Ed Dolan EdDolanJune 4th, 2012 at 12:46 pm

You are right. The ideal fiscal system for an optimal currency area is one that combines discipline in the parts with redistribution from the center to carry the parts through periods of fiscal stress. The US, with its large federal budget and strong state fiscal discipline is supposed to be able to do this; the EZ falls short on both counts. However, since 2008, the US federal government has not fully upheld its end of the bargain. I'll try to pull some numbers together and discuss this more fully in a future post.

aneconomicsenseJune 4th, 2012 at 12:46 pm

Excellent points. Fiscal drag is indeed holding back the recovery, and the only surprise is how few people actually look at the data that show this. Similar points have been made at the web site in a series of posts over the last half year, including one last week on the disappointing jobs and revised GDP numbers that were released. See:…. There are earlier posts at this site on the fall in government employment during Obama's term in office, and on how flat or falling government expenditures during the recovery from the 2008 collapse is in sharp contrast to the growth seen in government expenditures following previous economic downturns, including the one during the Reagan period. This by itself can largely explain why the economy is still far from full employment.

buzzJune 4th, 2012 at 3:04 pm

Hi Ed, thanks for the post. As a liberal with a classical liberal view on economic matters, I think your facts are right but your interpretations are off and your proposals are dangerous.

You're missing two things, mainly. The first is simply that we are living in the aftermath of a credit bubble. During a credit bubble, government enjoys elevated revenues and tend to raise spending in line. Bush was particularly bad, running deficits on top of bubble-inflated revenues. But even Spain which ran public surpluses during the bubble has got into big trouble funding itself after its huge bubble popped and public revenues collapsed.

There is no painless cure for this problem except to not get into a credit bubble in the first place. Countries that have followed the path you are recommending have mostly got into deep trouble, except some small countries pulled up by strong neighbors.

There are two ways to understand you. One is that you are assuming an American exceptionalism, a unique American ability to withstand >90%/GDP public debt without suffering a prolonged slump. I'm sorry but there is no reason to believe that. Two is that you subscribe to the DeLong-Summers "free lunch" theory. This is a theory based on presuming that any growth regardless of quality is sustainable growth. If that were true we would have had no recession.

Giving these sorts of prescriptions won't do liberal causes any good. If Democrats abdicate fiscal responsibility, voters will turn to Republicans. We will run right into a neo-Reagan revolution with a Tea Party tinge.

PS It's worth clarifying what the numbers that you call "the government's contribution to GDP" really are. They are not the government's own output. They are the share of output for which the government is considered in national accounts to be the end user. It's actually a fairly meaningless technical category, which reflects the methods of the data-collectors, not the purposes of data users. For example, households are considered to be the end users of Medicare and Medicaid spending but government is considered to be the end user of public education spending. Why? Because we've always done it that way.

Ed Dolan EdDolanJune 4th, 2012 at 5:10 pm

Thanks for the comment. You make some good points. I think you may be exaggerating our degree of disagreement, perhaps because I failed to express myself clearly.

1. I don’t subscribe to any free lunch theory. I don’t buy the idea that growth always pays for itself, and I don’t buy the exceptionalist brand of free lunch either, which I understand as saying that the US is gifted by our Creator with permanently low borrowing costs. On the other hand, I also don’t buy the confidence fairy brand of free lunch or the Laffer curve variant. Because there are no free lunches, there are always long-term costs to increasing the deficit and the debt, but there are also short-term costs of austerity. The absence of free lunches means that trying to engineer a fiscal consolidation in the middle of a slump has to be a balancing act between cutting too much too fast (as many think is being done in the UK) and doing too little in the hope that some miracle comes along. I thought Glenn Hubbard’s remarks on CNN were right on the mark when he characterized the problem as one of finding the right glide path to sustainability. My point is that we are closer to such a glide path already than many people realize, so that what we need to do now is think about other parts of the consolidation package.

2. “There is no painless cure for this problem except to not get into a credit bubble in the first place.” I partly agree with you on this, but it is not the whole story. Probably we are never going to avoid excessive booms and bubbles. The trick is to have a set of fiscal rules in place that force you to run a healthy surplus and pay down debts during the booms. Yes, Spain, also Ireland, Estonia, etc. ran small surpluses during their booms, but not big enough, and not as part of a credible, sustainable fiscal rule that would balance their budgets over a full cycle, prevent cumulative growth of debt from cycle to cycle, and provide the needed fiscal room for maneuver during downturns. I tried to deal with this issue in my posts of Chilean and Swedish fiscal rules a few months ago.

3. You are right that measuring the government’s contribution to GDP is problematic.

buzzJune 4th, 2012 at 9:53 pm

Thanks very much for pointing out where we agree. I have to say though I cringed at your comment on the "confidence fairy" as a type of "free lunch".

If your point is only that some people such as the UK Tories downplay the costs of fiscal consolidation and exaggerate how much confidence one can buy with it, you're right. They're politicians. The UK consolidation had significant costs, and the most that can be said for its affect on confidence is that it might have helped avoid more rapid deterioration given the negative domestic momentum and worsening external environment.

But fiscal consolidation does help restore confidence, and confidence is crucial. The lack of it explains why this recovery has been so tepid. In the US, business investment relative to GDP has been running at about one-third of late 1990s levels. I think it would be hard to argue that prolonging or increasing these high deficits would bring back confidence and generate private investment. It looks to me like a recipe for falling into a Japan-style trap of low investment and increasing reliance on financial repression to fund growing public debt service, which the US doesn't have the discipline to sustain.

There will always be irrational investment fads, but credit bubbles can be avoided with conservative monetary policy. The problem has been wrong economic theory which discounted the role of the credit cycle as the dominant driver of business cycles. Bernanke and others actually thought the very high volumes of net credit expansion relative to GDP in 2003-2007 weren't a problem. The academic economics field still hasn't really accepted that it was mostly wrong on that point, and that's worrying.

RolandJune 4th, 2012 at 7:21 pm

A thing I don't see talked about is the inflationary effect of increasing the money supply combined with the reduction in taxation for the very wealthy. It is apparent from experience that the result is to create asset bubbles one after the other as the wealthy chase yield – and the subsequent vaporization of wealth as the bubbles collapse. Conventional inflation doesn't occur because the increase in money supply doesn't get to the people who would spend it on consumables. All that happens is that wealth is rearranged among those who already have it.
We rely on money creation to solve our economic problems – since the political system is so obviously incapable of any constructive action. But if all it does is to allow and encourage the super-rich to gamble, it's not going to do much good.

ChadstoneJune 4th, 2012 at 9:32 pm

I agree that allowing all the "fiscal cliff" policies to go into effect permanently would be unacceptable because it would push an already vulnerable economy into recession. But as I argue in a new Center on Budget and Policy Priorities analysis (… ),the economic effects of letting those policies go into effect temporarily while policymakers worked seriously on a balanced and sustainable budget deal would likely be very modest compared with the longer term benefits of sound policies that both nurture the recovery and lower the deficit once the economy is stronger.

Ed Dolan EdDolanJune 4th, 2012 at 9:56 pm

Thanks for the link–a good read. I can see your point. I suppose it is really all politics whether delay gives us something worse, something better, or just delay for its own sake.

barfJune 4th, 2012 at 9:57 pm

the reason that "spending" as you define it is leveling off is obviously because "we're printing a Federal Program each week." You can call that austerity i guess but i would call that "mismanagement of Federal resources on the grandest of scales." In short: there's no accountability for the hundreds of billions being spent already. until that happens "expect more of what you call austerity." i respect you view on "foreign wars" but quite frankly "at least i know what i get when a buy a tank or submarine." the same cannot be said for a "government worker." (more than likely he's just hangin' out at the Diner with his buds collecting OT.) Quite honestly nothing you say here really makes sense actually because you don't seem to be calling for anything other than what we already have. How will that work? How about we start with opening up all the Federal DOT contracts for private bidders? How about governments start selling assets like airports and highways? How about we privatize the Postal Service? How about we use the internet for schooling our kids instead of busing them where they can be bullied and harrassed by a bunch of neo-lithic clowns? if i have to watch another "we love sports" thing in the USA i'm going to puke actually. the whole thing is corrupted by gambling and the mafia anyways. ridiculous. anywho…"we'll just do nothing" per your instructions and see what happens instead.

Ed Dolan EdDolanJune 5th, 2012 at 2:30 pm

Thanks for the comment. I actually don't disagree with you about busing and privatizing airports and all that. What bothers me about your comment is that you seem to have blinkers on that reduce all of fiscal policy to spending issues–how much and on what. Of course, those are worth looking at, but with total government spending already on a downward glide path, we need to turn our attention to other, even more important parts of the fiscal policy equation, specifically real tax reform ( which both the left and right in Congress, as well as the White House, seem unwilling to touch in any but the most general terms), and after that, some long-term policy rules that will keep things under control when the next boom comes. So, privatize all the airports you want, but don't mistake the part for the whole.

Steve-comeonAmericaJune 4th, 2012 at 10:55 pm

Is not Bush's big escalation Taarp and defense? A slow decline from a panic reactive increase is not much of a badge…how much decline for the Obama admin is defense? It is the slow, incestuous government "oversight" scope creep that seems impossible to retract. One can quit-stop a war and see billions fairly quickly.

We are so far from what this country was founded on. Try to explain any additional government growth-spending as a form of GDP to first generation Americans or to the Chinese…shame on us

dannyhJune 5th, 2012 at 9:20 am

RIght on barf! Let's replicate enron in all parts of our society. That will work great, assuming you get in on the ground floor.

Chris GuzmanJune 5th, 2012 at 9:47 am

I have to assume you're deliberately confusing the issues at hand in an effort to defend Obama.

Obama and the Democratic majorities in congress had a two year window to enact their policies in a united effort. Thus, the explosion in spending pertains to the federal government only, for largely that time frame. In the mid-term election there was a dramatic shift to the Republicans in the U.S. House, Governors, and state legislatures. By adding state and local expenditures, you're taking their hard work of balancing budgets and reducing costs and crediting Obama. Even though Obama and his party were the ones voted out of office for their spending policies.

One of your commentors mentions the total debt and its dangerous levels, yet you neglect to make any correlation to Obama's accelerated spending in spite of decreased federal revenue and significantly adding to federal debt.. The Keynesian effort was wasted.

As for your skirting the issue of entitlements as transfer payments that simply are beside the point is incredibly disingenuous. Entitlements are half the federal budget and contribute greatly to debt. Not acting on curbing its growth is a choice made by the Democrats and one they should be held accountable to.

Please don't portend to be objective when you clearly are not.

Ed Dolan EdDolanJune 5th, 2012 at 2:41 pm

I agree with some of your points, but please, let's not make this a partisan issue.

Yes, Obama wasted two years when he had a majority in Congress. I would have liked to see that opportunity used for some structural reforms of spending, not just stimulus, along with true tax reform (broader base, fewer loopholes, lower rates), not just a fruitless discussion of whether the middle class or 1% are paying too much or too little, etc. I would have like an outright endorsement of Simpson-Bowles despite its imperfections. It did not happen. Sad.

Don't forget, tho, that GW Bush wasted 8 years. He not only did none of the above, he wrecked the bipartisan consensus of the 1990s that actually improved the quality of fiscal policy for a while and brought down the debt. Instead, we got off-budget foreign wars and an unfunded Medicare Part D, not to mention unsustainable tax cuts that were falsely sold as temporary.

Can I say it often enough? Our fiscal mess is not a partisan problem. The more partisan we are in our approach to it, the worse it gets.

TrentJune 5th, 2012 at 5:21 pm

Whats funny is how some people here have decided that the bubble has already burst, but i tend to feel that we had mutiple bubbles running at the same time. Only recently has the media began to speak about a "higher ed" bubble, and i can't help but notice that endless credit from insurers and the government have inflated the prices of healthcare every year for the past however many. Maybe its because i live in pittsburgh and see these bubbles working everyday that i feel the way i do, but i think we are nowhere near out of the woods and any talk of recovery is the product of someone who has "blinders" on. Mr Dolan, what say you of the largest bubble of them all DEBT?

Ed Dolan EdDolanJune 5th, 2012 at 5:58 pm

You have a point. Bubbles are everywhere if you look for them. Have you checked out the website You'd like it.

Speaking seriously, you are not alone in thinking there is a bubble in US government debt. Low yields on treasuries mean prices as high as Tulips during the mother of all bubbles.

dajeepsJune 6th, 2012 at 10:17 pm

Sorry if this seems like a silly question, but coming from a history and political science background I am having trouble wrapping my brain around this:

"The trouble is that populaton, capital, and productivity have increased since 2007, raising potential real outuput–the normal level that would prevail when the economy is neither in a state of boom or bust. As a result, unemployment is still above its natural level. "

I was under the impression that wage rigidities and lack of clearing in the employment market explained the bulk of the nagging unemployment problem, but this seems to be a different take. Maybe it is just another way of saying the same thing or am I conflating initial causation with current conditions in my understanding?

At any rate, I think the government does need to be rationalized, and I somewhat agree that we shouldn't try to do it in one big chunk or we will end up with a sort of feedback loop that makes the debt and spending problems worse in the short run. This, what seems like an extraordinary economic problem, doesn't appear to be so much of a problem of efficiency as much as a lack of stability in expectations regarding nearly everything from politics and public policy to markets and monetary policy, of which, nearly everyone with a role to play, from the President and other political leaders to the Fed Chairman are having problems providing. I don't intend to detract from the efforts each have made, as the crisis we faced was of historic magnitude, but I think they sometimes forget that it isn't so much about what is being done, but how one is perceived as they do it.

Ed Dolan EdDolanJune 7th, 2012 at 1:32 am

As the saying goes, the only "silly" question is the one not asked.

Your question is being asked by many economists. There is a big controversy over how much of the current unemployment is "structural" and how much is "cyclical". Structuralists say basically that the decrease of potential output has decreased job openings because people lack the right skills, some sectors like housing are never going to recover, trade has permanently destroyed some jobs, etc. The "cyclical" side says the jobs would appear if there were enough fiscal and monetary stimulus to overcome temporary factors like wage rigidities and slow clearing of the market. Each side presents regressions and theories to establish its case, and the answer really isn't clear. My own opinion is that structural factors have reduced potential GDP somewhat below its former trend, but that we are not presently even back to the reduced trend.

So your question is a good one, there just isn't a clear answer yet.