9/30/13 – Here Comes the Shutdown

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 30, 2013 8:19:19 AM

and tagged Fiscal Cliff, Debt Crisis, Politics and the Economy

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Here we go again. I’ve written something to that effect several times over the past couple of years, what with the 2011 debt ceiling debate, the 2012 fiscal cliff, and now this. Governmental dysfunction has been normalized.

The phrase that comes to mind is “defining deviancy down,” from a 1993 paper by Daniel Patrick Moynihan, one of the great statesmen of American politics. The idea is similar to the boiled frog theory I described last month: with every ratchet down in behavior, the new low becomes somehow normal, and any subsequent changes are perceived as being less bad (compared with the new “normal”) than they would have been otherwise. Another way to describe it is a behavioral downward spiral—that is, behavior that formerly would have been thought absolutely disgraceful is now seen as somewhat embarrassing.

Which brings us to the shutdown. Assuming neither house of Congress wanted to go into the debt ceiling debate under the massive additional pressure of a government shutdown, I figured they’d cobble together a last-minute deal. That is certainly still possible, but both the House Republicans and Senate Democrats have used rhetoric and parliamentary procedure to make such a deal very unlikely. I think the betting now has to be that the government shuts down, which takes us into a debt ceiling debate that’s even nastier and more partisan than anyone expected.

The immediate consequences will be approximately 800,000 federal workers furloughed, suspension of “nonessential” federal services, and no pay for the remaining “essential” federal workers. “Essential” has some broad outlines, but military personnel, for example, may not get paid, and there is a great deal of uncertainty as to exactly what might happen. That uncertainty will be a key driver of the damage done to the economy.

The direct economic damage should be small, at least initially, limited to the loss of spending power by federal workers and the government itself. The direct effects over time would be similar to those of the sequester, and for similar reasons, but should occur mostly or solely within the period of the shutdown. Fourth-quarter GDP would be hurt, but there should be no direct effects beyond that—assuming the shutdown doesn’t extend past the end of the year.

The indirect effects are what should worry us. When we look at economic growth in the fourth quarter of last year, we see a big fat zero—largely caused by the political uncertainty generated by the fiscal cliff. When we combine the government shutdown and the risks associated with the pending debt ceiling, we have something even bigger than that. What’s worse, with the fiscal cliff, we had a worst-case solution in place—it was bad, but at least it was defined. Now, however, we have no idea how bad it could be. If the U.S. government were to default on its obligations, the long-term effects could start where the fiscal cliff stopped.

That said, I’m not worried about that outcome—yet. Even if we go past the debt ceiling, which appears increasingly likely, the Treasury can probably continue to manage the situation to minimize the damage. I acknowledge that this is another example of normalizing dysfunction, but, just as with the sequester spending cuts, the damage can most likely be contained for a while.

The immediate worry will be the effects of uncertainty on the U.S. economic recovery. We have a sustainable recovery under way, but it is still subject to external shocks, like the one about to start. A rerun of the fourth quarter of last year, where consumer spending and business investment tanked while citizens tried to figure out what Washington would do, is looking more and more likely. Taking growth back to zero would kill most of the economic momentum we now have.

Meanwhile, from a personal perspective, I have to prepare my quarterly review of the economy and the markets. In normal times, I would have written most of it last week. In less strange times, I could have finished it today. As it is, we will be down to the wire, and I’m waiting until tomorrow to write it, as I don’t really know how the month will end. Over to you, Messrs. Boehner and Reid.

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