On the sequester and the potential for a US government shutdown

As you know, in mid-January I had said I expected a recession in Q2 as a result of austerity and a government shutdown in the US. Recently, however, I have moved away from that position as a baseline, largely because of the rebound in housing and the potential to avoid a shutdown. Housing impacts the economy by adding to GDP in all the housing-related sectors. But, more importantly, the floor on house prices moves people into positive equity, fuelling mortgage refinancing and adding to disposable income. This is the credit accelerator at work. And while we can question its sustainability in the absence of true income growth, it does have powerful cyclical effects. We should just eke through then.

So, I don’t think we get to recession yet. The real question on recession is whether the President and Congress fail to lift the sequester and a government shutdown ensues as well.

First, let’s remember as well what the magnitude of the GDP losses from austerity are. The US government’s fiscal tightening amounts to 4.8% of GDP, which is greater than the planned eurozone tightening of 4.1% over the same period. Gavyn Davies put forward these numbers in a recent post in the FT. And they sound credible when you look at the euro zone as a whole, not at specific countries like Portugal where the tightening has been more severe. Now, Goldman says the combined impact of fiscal measures taken so far is about 2.5% in Q2 and 2.2% in Q3 on an annualized basis.

And this jives with what we saw in terms of estimates early in the fiscal debate. The reductions are now much more than the best case clifflet of a reduction of 0.9% of GDP that I told you to expect in October.

Nevertheless, the uptick in the US economy says the the baseline for private sector growth at this point in the business cycle is slightly above the 2.5% fiscal drag from the austerity. And that means we are just eeking out a stall speed kind of scenario in Q2 and Q3 where I see the greatest potential for renewed recession. However, in my view, if we do not get a deal on the sequester and we end up in a government shutdown come March 27th, the US will indeed go into a recession. The reason I have backed away from predicting recession is that it is not clear that this will occur because it is less advantageous now politically.

If you recall, when I wrote the sequester will happen a month ago on February 4th, I linked to a Politico post that said Washington insiders expected a post-sequester deal to be hammered out so that the full impact of the sequester would not occur. And the President is offering deals to make this happen – deals that go very much against the grain of his party. I think a deal is likely but I don’t have any conviction about this because it really is very much up in the air and politics is unpredictable. After all, I used to think differently.

The bottom line is this: if we get a deal as I now believe we will, we skate through into stall speed in Q2 and Q3. If not, we could get a shutdown as I previously believed to be the likely political outcome. And then recession is likely.