Flying Blind: Forecasting with No Data or Endgame

Heightened Uncertainty

Everything from the government shutdown to posturing regarding the lifting of the debt ceiling has heightened uncertainty about the economic outlook. Consumer and business confidence have fallen since the threat of a shutdown emerged, while the reality has taken a toll on communities where a large number of federal workers have been furloughed. Everyone, from cab drivers to restaurant owners, small retailers and (largely) defense manufacturers, were affected in the early days of the partial shutdown of government agencies.

Steve Stevens, the President and CEO of the Northern Kentucky Chamber of Commerce, who joined me on the NPR radio show “On Point” one day into the shutdown, cautioned that “restaurants, retail establishments, etc. that were all in that general vicinity [of a large IRS office] didn’t have that very many people in them when it was time for lunch, or at other times of the day.”

Some 3,000 of those government workers in that location were deemed nonessential and sent home. That means less spending, fewer hours worked and smaller incomes for the businesses in and around that office.

Add to that, a suspension of economic releases and data gathering by the government and doing a forecast in the current environment is much like flying blind; we know we are in the air but our view is so clouded, it’s unclear whether the economy is poised to reaccelerate or take a nosedive back into recession. A breach of the debt ceiling, even for a short period,would most certainly cause lasting and unimaginable damage to the economy. The U.S. dollar is still the world’s reserve currency, so U.S. Treasuries are considered “risk-free” and provide the basis for pricing riskier assets the world over; if their value becomes uncertain, then so does the price of everything else. The resulting financial crisis would be unprecedented in scope and exacerbated by the immediate blow to the economy, triggered by a full government shutdown with no exceptions or prioritization.

The good news is that a growing number of members in both political parties are starting to acknowledge those risks and attempting to avert a crisis. The bad news is that the rhetoric from House Speaker John Boehner, who decides if legislation comes to the floor for a vote or not, has waffled on the topic of the debt ceiling. This has increased uncertainty over the duration of a government shutdown and the degree to which we could see tensions flare in the days leading up to the deadline to raise the debt ceiling. Further complicating matters is uncertainty about exactly when we will breach the debt ceiling.

A surge in revenues in September, coupled with a government shutdown on October 1, leads us, along with friends in Washington who closely follow the budget process, to conclude that the debt ceiling deadline could be delayed until November, despite Treasury Secretary Jack Lew’s stated deadline of October 17.

Political posturing is nothing new; it’s a key aspect of negotiating. The problem is that negotiations in Washington must lead to resolution in order to become law. Budget bills need to be passed by the House of Representatives, approved by the Senate and then signed by the President. Speaker Boehner’s current proposal, extended with a laundry list of conditions, does not have enough votes to pass in the Republicandominated House, let alone clear the Democrat-controlled Senate.

One way that Boehner could get a continuing resolution to restart government operations would be to limit his goal to funding the government at last year’s level minus $110 billion as required by sequestration in 2014. That would require him to build a coalition with Minority Leader Nancy Pelosi, who could then deliver the House Democrats’ votes needed to approve and send the bill to the Senate. That sequence of events, however, could cost the Speaker his job.

A more likely scenario is that a combination of sidebar negotiations between Republicans and Democrats takes hold. My friends close to the Capitol tell me that we were close to such an outcome during the Fiscal Cliff negotiations last year. The backlash from the public and the markets over the shutdown combined with the risk that the debt ceiling may be breached, could finally force some kind of a larger compromise on the budget. Public opinion polls have already tanked in reaction to the shutdown. Responses show Republicans taking more blame than Democrats, however, which could force Speaker Boehner’s hand. Even Republican Party Strategist Karl Rove has publicly come out against hardball tactics, for fear they could cost the GOP seats in the 2014 Congressional elections.

We are expecting the government to be shut down for at least two weeks. If and when we enter week three, the costs associated with shutdown start to compound fairly rapidly. That is especially true if the debt ceiling deadline is not pushed beyond October 17. This report takes a closer look at the costs of political gridlock. The direct costs associated with the government shutdown could be recouped fairly quickly, within a quarter or two. The collateral damage associated with gridlock, however, is mounting and already hurting our ability to compete. The fate of the economy, its recovery and growth potential, is literally in the hands of Washington politicians. (That is one of the scariest sentences I have ever written.)

Context: It is not 1995-96

Our most recent benchmark to assess the costs of a government shutdown is the pair that occurred in 1995-96. That experience showed us that most of the losses caused by government shutdown, including some hesitation by consumers and businesses, were recouped fairly quickly in the two quarters that followed.

The problem is that we are not in 1995. Back then, the Fed was stimulating the economy with a traditional drop in shortterm interest rates; a technology bubble was emerging; and, everyone was confident (complacent) that the good times would never end. That delivered us 1996, the year that ended with Former Fed Chairman Alan Greenspan’s warning about “irrational exuberance.”

Today, fiscal policy is tight; monetary policy is unconventional; and, uncertainty about the future is extremely high. The result is a much more fragile recovery, as more people are put at risk by a government shutdown, with fewer buffers against external shocks. This is to say nothing of the additional financial stress that government workers face this time around, given years of pay freezes and uncertainty over their jobs; the 2014 round of sequestration will force more job cuts and unpaid furloughs, once government reopens. This could lessen the rebound in consumer spending, as those workers will now save more and spend less during the critical holiday season.

Near Term Costs

Take 0.3% Off the Top

Our current forecast incorporates a shutdown lasting two weeks (give or take a few days), with furloughed government workers compensated retroactively once they return to work. (The need to incent workers to make up for time lost during the shutdown is the primary reason.) Last week’s bizarre ramming of a White House barricade, followed by a car chase and shooting near Capitol Hill, likely played a role; Capitol police are unpaid and understaffed for the duration of the shutdown.

Separately, the Pentagon was able to recall more than 400,000 workers for national security reasons. That was after James Clapper, the nation’s top intelligence official, warned Congress that the shortfall in intelligence from the shutdown made us more vulnerable to a terrorist attack and offered “… a dreamland for foreign intelligence services to recruit.”

The result is 0.3% less real GDP growth than we would have seen in the absence of a shutdown. (That figure allows for recouping some of the losses from the shutdown, once government workers return, get paid and clear the backlogs.)

Another -0.2% in Collateral Damages

Delays in everything, from home mortgage approvals to small business loans and the collateral damage to manufacturers, retailers and restaurants, is adding insult to injury. Many service sector workers will never regain the work hours and lost pay due to the shutdown.

This is to say nothing of the hits to tourism and consumer pocketbooks created by national park and museum closures. Many travel and hotel expenses, already paid for, will not be reimbursed. The working poor and the millions still on long-term unemployment are at particular risk. The shutdown has eliminated after school programs, which substitute for daycare; that forces parents without alternatives to work fewer hours and earn less pay. Food subsidy programs have been suspended, increasing the urgency for lower income households to earn more. Meanwhile, delays in hiring could force those who have already been unemployed for a long time to give up looking for work entirely.

Data Drought

Separately, there is the transitory and potentially permanent loss to government statistics. The most important economic report of the month, the employment report, was already delayed for September.

If the shutdown lasts past Columbus Day, however, the employment report for October, which provides seed data for a slew of other critical measures of the economy, may not be done at all. That, combined with the loss of other key, time-sensitive data surveys could leave us in the dark about the performance of the economy through January of 2014 (or much longer, as noted in the Financial Times). It would leave economists flying in a fog with no horizon in sight; we wouldn’t know if the economy is cruising right side up or upside down.

Those losses will compound uncertainty about current economic conditions, complicate estimates of the costs of the shutdown and could rock financial markets; uncertainty is the enemy of investors.

Separately, the shutdown could further delay the Federal Reserve’s decision to begin tapering its large-scale asset purchases. The Fed was widely expected to start tapering in September but decided to postpone that action, at least in part because of the risk of a government shutdown and a showdown over the debt ceiling, which could further stunt economic growth. No tapering is likely now until January.

Long-Term Consequences

Even more difficult to quantify are the costs associated with gridlock over the long term. Critical trade talks with Europe, Mexico and Canada were shelved during the height of the 2011 debt ceiling debacle; that is leaving us behind our key trading partners in getting access to critical markets.

Last week, trade talks with Europe were further delayed when President Barack Obama cancelled his trip to Brussels to deal with the government shutdown. Trade talks with Asia, where China is gaining both economic and political influence, were also shelved. That could undermine our economic competitiveness as well as our standing and credibility on the global stage.

Richard Haass, President of the Council on Foreign Relations, worries that gridlock could undermine the influence the U.S. has in global relations. It’s hard to preach the advantages of democracy when our own system appears to be broken.

Add to that, complete and utter inaction on immigration reform, which is already hurting innovation and our ability to generate new jobs here instead of abroad, and it is clear that our competitiveness has already taken a blow. Silicon Valley needs to recruit the best and brightest in the world to stay on top, and simply can’t do so with current visa limits.

A Silver Lining

There is a silver lining. Some in Congress are working to reignite broader budget negotiations that would take the debt ceiling off the table for a while and begin to provide some certainty on fiscal policy. Political strategist Greg Valliere of Potomac Research outlined his “God for a Day” vision of what could be done, given burgeoning negotiations:

•…an immediate end of the shutdown; a $1 trillion dollar debt ceiling increase; the easing or abolition of the sequester; and no major changes to Obamacare. That’s what the Democrats would get. For the Republicans: major entitlement reforms, including a change in the Social Security COLA; approval of the Keystone pipeline; a binding commitment to tax reform; and perhaps abolition of the (medical) device tax (giving up $30 billion in revenue over ten years; that might be offset by cracking down on some tax breaks like carried interest).

None of that, however, could happen this year; the best that could be accomplished is agreement to discuss the issues with a higher level of commitment. (Don’t be surprised if we get another “Blue Ribbon” bipartisan panel, as we did in the wake of the 2011 debt ceiling debacle. Of course, the members failed to come to a consensus on what to do, despite the threat of sequestration.) A more likely outcome is some kind of a temporary agreement to reopen government and lift the debt ceiling. That would buy us time, but continue to fuel uncertainty.

Bottom Line

The government shutdown and threats regarding the debt ceiling are adding insult to injury to an economy that was weaker than hoped, entering the fourth quarter. Most believe that an actual default on our credit obligations will be averted, but not without a “kick the can down the road” solution, which would keep uncertainty high through year-end.

There is some upside risk of a broader budget agreement, which would still result in spending restraint in 2014, but increase certainty in the medium term. This would help rather than hinder growth relative to where we are today. I am only cautiously optimistic, mostly because I am tired of our government failing us.

© Mesirow Financial

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