Fiscal Policy: The Same Old Drag

Among the many fears shared by investors these days, concerns over fiscal drag have recently risen to prominence. Watching the pattern of the "fiscal cliff" negotiations and anticipating the results of deliberations on the debt ceiling, as well as the sequestration of defense and other sorts of discretionary spending, investors have begun to anticipate some combination of tax hikes and spending cuts that would slow the pace of economic growth. And they have good reason too. Though no one yet can know the specifics of Washington's coming compromises, these will no doubt impose the anticipated tax hikes or spending cuts, and these will indeed hold back the pace of economic growth. Still, it would be a mistake to anticipate too much of a shock. The country, after all, has suffered fiscal drag for some years now. Any future drag will not likely differ much from this past. Even with failure in Washington, a moderation in cutbacks at the state and local level should allow government overall to offer the economy a measure of relief.

The story of fiscal drag during these past few years begins with the immense stimulus spending of early in 2009. One of President Barack Obama's first acts as president was to seek and get huge increases in government outlays, more than $800 billion, according to the Treasury Department, aimed at improving the nation's infrastructure and supporting hard-hit state and local governments. Federal spending on wages, salaries, goods, and services shot up, according to the Commerce Department, almost 10% in real terms from early 2009 to mid-2010 or at a 6.3% annual rate. That spending growth was far faster than the overall real economy, which expanded during that time at only a 2.0% annual rate.1Though state and local governments then faced tremendous budget problems, expanded flows of federal dollars to them, at an almost 18% annual rate, allowed states and localities to increase their spending on wages, salaries, goods, and services at a yearly rate of 4.6% through the middle quarters of 2009.2

But before that first year of the Obama presidency had ended, the great stimulus program had begun to exhaust itself. Flows of federal dollars began to fall. Real spending by Washington on wages, salaries, goods, and services peaked in spring 2010, fell slightly during the second half of that year, and then began a steep slide that took it down almost 4.5% in 2011 and almost 3% in 2012. This was significant fiscal drag in and of itself. But because at the same time the federal government began to withdraw its previously generous support to state and local governments, their spending also sank. Even before 2009 closed, real spending by state and local governments on wages, salaries, goods, and services had dropped and then, along with such spending at the federal level, sank more than 3.5% in 2010, more than 2.5% in 2011, and almost 1.0% in 2012.

Against this multiyear history, the impending federal sequester looks less like a shocking shift toward fiscal drag than simply a little more of the same. Even if Washington were to allow the entire $85 billion sequester of defense and other discretionary funds for the coming year, which is hardly likely, and even if it were to impact the government's spending stream immediately, also unlikely, the economy at worst would feel two-thirds of the impact in the coming four quarters. Even this unlikely extreme would amount to a 5.5% annualized drop in real spending—a larger fiscal drag than in recent years, to be sure, but not a radical change. If it continued to hold back the pace of overall economic growth, it certainly would not rock economic reality, as some of the more hyperbolic commentary coming out of Washington suggests.

Meanwhile, matters in state and local government have begun to stabilize, certainly compared with this recent past. Because declines in federal support during the last three years have brought this flow of funds back to trend, it is not likely to fall much farther, though the budget debate in Washington suggests that it will not likely rise either. Though it is no source of growth, this shift will still constitute an improvement over the patterns of 2010–12. Meanwhile, the modest improvement in the economy has begun to raise state and local tax revenues, at more than a 2% annual rate, according to the Federal Reserve, during the past year through this past September (the most recent period for which complete data exist). State and local budgets are still far from secure, but the improvement in tax revenues and the relative stability in federal flows going forward should help stabilize their spending, surely an improvement over the declines of 2010, 2011, and 2012, and a mitigating influence on the economic ill effects of the fiscal drag still emanating out of Washington.

There is nothing in prospect for the overall government sector—federal, state, and local—that says stimulus. Fiscal restraint ("drag" in the vernacular) will certainly dominate the future for some time to come. But even if the sequester negotiations fail utterly, the degree of drag at the federal level will at worst increase its intensity only modestly and perhaps not even that much if the budget negotiations go better. Meanwhile, moderation in the pace of decline among state and local governments points to less net drag from the government sector as a whole, certainly relative to the recent past. The impending negotiations in Washington are important. They can make matters marginally better or worse, though the kind of fiscal reform investors want is almost certainly off the table. But if these matters still have the power to shock psychologically, they would seem to have much less economic potency.

1All data from the U.S. Commerce Department, except where noted.

2Data for state and local government are from the Federal Reserve.

I would like to thank Steve Lipper, Lord Abbett Investment Strategist, for suggesting this line of thinking.

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