The Mess We’re In – Trillions of Dollars of Missing GDP

According to the Congressional Budget Office (CBO) the U.S. has a cumulative output gap of $2.8 trillion so far since the recession began.  That’s trillion with a TR, as in a million millions.  This is the core problem in the U.S. today and for the next couple years.  The recession saw the economy shrink and we simply haven’t aren’t getting back to where we were, let alone to where we could be.

Two of the most basic concepts in economics are the idea of opportunity costs and the technique of the counter-factual.   Both play a part in this analysis.  First, opportunity cost is the idea of the real cost of something or some choice isn’t the money expended but rather what you could have done but didn’t/can’t because of your choice.  Analyzing opportunity costs involves using the other idea, the technique of the counterfactual.  A counterfactual is a hypothetical outcome that could have been or even would have been, but didn’t happen because of the choices made.  People use counterfactuals often, they just don’t call them such.  For example, if you imagine decide not to go to a party and you choose to stay home one night, you might imagine what would have happened if you had indeed gone to the party.  That’s a counterfactual.  It could be good and attractive (you would have had fun at the party and met someone very interesting) or it good be negative (you would have gotten drunk, tried to drive home, and got arrested for DUI).  Comparing actual events to counterfactuals is integral to economic analysis.

In the case of macroeconomics, we often use a counterfactual called “potential GDP”.  Potential real GDP is the amount of real GDP that would have been produced IF we had made policy choices that produced full-employment.  In practice potential real GDP is often estimated by a combination of extending the long-run trend line of GDP from previous decades and of calculating output per worker and multiplying times the number of potential workers.  In this case, the additional workers include not only those presently recorded as “unemployed” but also those workers or part of the population that used to work but are no longer working or classified as unemployed.  It’s a fairly involved statistical undertaking, but fortunately we have the CBO to do the heavy lifting for us.  The numbers and graphs are accessible via the wonderful FRED database at the St.Louis Federal Reserve bank.  The data series is called GDPPOT.

The CBO released it’s latest long-run estimates for GDP.  Here’s a graph comparing potential real GDP to actual Real GDP. It shows actual numbers for 2008- first half of 2011.  From then on it’s the CBO’s best estimates of future actual real GDP given present government policies.

Yeah, that’s an ugly gap between those two lines.  That’s the opportunity cost of lost potential.  We could have been $2.8 trillion dollars better off over the last 3 years (cumulative, not annual). We could have had tens of millions more working. But we didn’t.  More disturbing is that we will continue to underperform for many years.  The CBO doesn’t project getting back to full-employment and our achieving our potential output until the end of 2015 – four years from now.

But now here’s the catch.  The CBO estimates and analysis don’t offer any rationale or reason why they suddenly forecast a recovery in 2015.  Basically they are saying that surely something will happen in 2015 to bring recovery, but they can’t point to any policies or dynamics that will cause such a recovery.

My own sense is that this will take a lot longer to recover given the government’s current focus on debt, deficits, and cutting spending.  It’s the wrong policy mix to achieve full employment given this kind of output gap.  We will eventually get back to full employment – if nothing else, sooner or later people die off and equipment rusts away.  But we’re in the middle of an ongoing depression and current policies won’t change that.  (note I said depression, not a “Great depression”)

 

Hurricanes, Disasters, and GDP

Ok, normally I’m writing about the disastrous effects of changes in GDP.  Today, though, I’m going to write about the effects of disasters on GDP. As I write this, it’s mid-day on Saturday, Aug 27.  Hurricane Irene has just hammered North Carolina and the Outer Banks. Irene is continuing in both it’s push up the Eastern seaboard toward New York City.  I have no idea at this moment how bad the damage will be.  What’s clear is that even if the storm weakens to a tropical storm strength, it will bring extensive flooding and wind damage across a very heavily populated area.

Major natural disasters generally do not have a major long-run effect on the economy and GDP.  This is largely because the U.S. is a really large nation and even the most severe natural disasters such as Hurricane Katrina only directly affect a small portion of the country.  So even if a hurricane or earthquake were to stop 40% of the economic activity in a region, as long as the region is only say 2-5% of the nation, the net effect is a short, temporary “blip” on the nation’s GDP.  Hurricane Irene could conceivably be different because the projected path includes over an estimated 65 million Americans – nearly 20% of the nation.

Asking what the effect of a natural disaster will be on GDP is probably the wrong question to ask.  What we’re really interested in is “what is the effect of the natural disaster on the economy and our living standards?”   It’s just that we are so accustomed to using GDP as a proxy measure for the size of the economy and our living standards.  Unfortunately, GDP as a measure of the economy and our welfare has some weaknesses.  These weaknesses are really important in the case of a natural disaster and interpreting it’s effects.  GDP measures economic production by counting the dollar value of all transactions where something new is produced and sold.  GDP doesn’t measure the value of what we own – our wealth. GDP doesn’t measure the value of services produced that aren’t sold (like charitable acts, household production, etc).  GDP doesn’t measure our capability to produce.  It only measures what we actually produce and sell.

The economic effects of a natural disaster are to change exactly these things that GDP does not measure. The primary economic effect of a major disaster such as an earthquake, hurricane, extensive flooding, or  a swath of destructive tornadoes is to destroy wealth and destroy our capacity to produce.  In macroeconomic terms, a natural disaster is a sudden reduction in our resources: capital equipment, buildings, and available labor. None of this is a good thing.  It reduces our ability to produce goods and services in the future and it reduces our welfare right now.  But that effect won’t show up in GDP measures.

What will show up in GDP measures after the natural disaster is a perverse reaction in the months after the disaster.  This comes because of the re-building activity that comes after the disaster.  Repairing buildings, cleaning up, rebuilding all require paid services, building supplies, labor, etc.  These transactions will show up in GDP measures in the months/quarters after the disaster as an slight increase in total GDP.  But it’s a deceptive increase in total GDP because we aren’t really significantly better off.  We’re just getting back to the condition before the disaster.  GDP counts the fixing, but not the damage done.  This is why we sometimes here commentators say that a “disaster is good for the economy”.  It isn’t really.  It’s good for GDP, but that’s not a perfect measure of the economy.  The mistaken idea that damage or disasters are good for the economy is what economists call the Fallacy of the Broken Window. It was first explained by Frederic Bastiat.

Normally the economic impact a natural disaster will be relatively short-lived so long as there is a mechanism to finance reconstruction and the real resources in the larger nation to do it.  Typically in a developed nation like the U.S., the financing for reconstruction comes from insurance company payouts and government, especially national government, loans and payments. In particular it is the responsibility of the national government to help rapidly restore infrastructure.  If adequate financing and national resources exist, then we rarely find a national impact on GDP or the economy lasting beyond perhaps a 6 months to a year.  The smaller the economy, the greater the potential for longer lasting damage and even a failure to rebuild at all.   That’s the problem in New Orleans five years after Katrina.  The city is now permanently smaller since large numbers of people chose not to return and rebuild.  At the U.S. level, though, it’s insignificant.

The lack of financing and resources can severely damage a very small or poor nation for a very long time.  That’s why Haiti, a small and poor nation, is so dependent upon outside help to rebuild. The other exception that can result in lasting damage and reduction of the economy is when the disaster brings permanent physical damage that cannot be repaired or rebuilt easily.  The nuclear disasters in Chernobyl and possibly Fukishima fall into this category.

So overall, a natural disaster is not likely to be a long-term significant

 

GDP for 2nd Quarter Revised Downward

As is normal practice, the BEA released the second estimate of 2nd quarter GDP growth.  GDP growth was definitely even slower in 2nd quarter than previously reported.  CalculatedRiskBlog tells us:

From the BEA: Gross Domestic Product, Second Quarter 2011 (second estimate

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 1.0 percent in the second quarter of 2011, (that is, from the first quarter to the second quarter), according to the “second” estimate released by the Bureau of Economic Analysis.

This was revised down from 1.3% and slightly below the consensus of 1.1%.

Exports subtracted more from GDP – as did changes in private inventories. Consumption of services and fixed investment were revised up slightly.

The following graph shows the quarterly GDP growth (at an annual rate) for the last 30 years. The current quarter is in blue.

GDP Growth RateClick on graph for larger image in graph gallery.

The dashed line is the current growth rate. Growth in Q2 at 1.0% annualized was below trend growth (around 3%) – and very weak for a recovery, especially with all the slack in the system.

Calculated Risk goes on to report on the breakdown of what sectors accounted for what part of the growth (or absence of growth).  The two most significant negatives were Personal Consumption of Goods and State/Local Government Spending.  Both contracted sharply and each had the effect of lowering the GDP growth rate by 0.34 points.  A 1.0% annualized growth rate is really not good at all.  It’s horrible in fact.  And that means it’s not the time to be cutting state and local government spending.  The federal government really could do something but there’s no political will in Washington.

Would a Balanced Budget Amendment Help or Hurt?

One component of the deal to raise the debt-ceiling is a requirement that Congress vote later this year on a “Balanced Budget Amendment” to the Constitution.  Is such an amendment a good idea?  At first glance, the idea seems attractive to a lot of people for whom the debt and deficits are seen as the key problem facing the economy (I am not one of these people).  After all, if you believe debt is bad, and debt comes from having deficits, then why not just pass a law amendment to the constitution that prohibits deficits, right? Well there are several problems with the idea.  Some are strategic – it’s really not a good idea to force a balanced budget every year.  But other problems are practical – the amendment, particularly as proposed now, simply wouldn’t work and would set up perverse incentives. Let’s look at these problems.

First off, there’s a bit of false advertising on the part of advocates of the “balanced budget amendment”.  The reality of what has been proposed goes beyond requiring a balanced budget.  A balanced budget would simply require government revenues to equal government expenditures each year.  The currently proposed amendment is really a “balanced budget with a strict cap on spending amendment”.  It has two parts. Not only would the budget have to be balanced each year, but the government spending would limited to 18% of GDP unless overridden by a 2/3 majority of Congress. The spending cap would limit government expenditures even if the budget were balanced.  The advocates of the balanced budget amendment, most of whom are Tea Party Republicans, are really proposing to re-write the Constitution to make it impossible for a majority of the duly elected Congress to expand the government beyond the limits they want.  It’s a rewrite of democracy.

The amendment and the spending cap in particular are totally unworkable in a practical sense.  First, the amendment and spending cap assumes that GDP and government spending are independent variables.  They aren’t.  In fact, government spending (G) helps determine GDP both directly since it  is a component of GDP and indirectly since the other components, consumption spending (C) and investment spending (I) and net exports (X-M) are themselves partially functions of government spending.  GDP = C + I + G + (X-M) by definition.  If you cut G, you cut GDP.  Suppose GDP = 100 and G = 20.  That’s government spending is 20% of GDP.  That would be too high under the amendment and would require a cut of government spending – revenue increase would not be allowed.  So suppose government cuts it’s spending to 18.  Keep in mind such a cut would be monumental. That would be a 10% (2/20) cut in government spending and we just had a paralyzing debate in Washington over how to cut spending by only 2-5%.  Imagine trying to cut 10%!   But even if the government did it, it wouldn’t work.  Because cutting government spending from 20 to 18 would take GDP down also.  The cuts would reduce both numerator and denominator.  If spending were cut to 18, then GDP would be no higher than 98, still leaving government spending as 18.37% of GDP. It would still be above the limit and require even deeper cuts which would then also cut GDP.  The reality would be even grimmer because C, I, and net exports all are partially influenced by government spending.  If you cut government spending for example, the people who got paid that government money, be they defense contractors, Social Security beneficiaries, teachers, or Medicare doctors, experience lower incomes.  They then cut their consumption spending and investment spending.  This is called the multiplier effect.

The practical problems are even greater when revenue is considered.  Government revenue, or taxes, are effectively a % of GDP.  That’s because virtually all the money collected by the government comes from GDP-related activity. Virtually all government revenue is either income taxes, payroll taxes, corporate profits taxes, or excise taxes on things that are used in production like gas.  If GDP goes up, then taxes collected goes up. If GDP goes down, then taxes go down also. Government spending goes in the opposite direction. When GDP goes up, many spending categories decline like unemployment compensation, welfare, Medicaid, etc. When GDP goes down, those spending items go up automatically.  These are called automatic stabilizers and they’re a major reason why recessions after World War II had been so mild compared to the depressions experienced routinely before WWII.  A balanced budget amendment means getting rid of automatic stabilizers and making mild recessions into worse recessions or even depressions. As  Simon Johnson at Baseline Conspiracy  put it:

 It makes no sense to target, as a matter of constitutional process, two numbers that are both outcomes of deeper economic processes.

A second very serious practical problem is with measurement.  GDP, while it’s commonly used and accepted, is only an economic concept, not a legal one.  The definition and calculation of GDP is subject to interpretation and depends on the prevailing views of statisticians and economists during any such era.  Simon Johnson at Baseline Conspiracy explains:

But GDP is not a legal concept – rather it is an economic measure, the details of which change all the time, subject to the prevailing view of best practice among statisticians.  Just to take one example, the flow value of housing services for people who own their houses is “imputed” to create a number that is roughly equivalent to what renters pay.  The goal is to more accurately measure a key component of consumption, which comprises the largest category of spending within GDP.  But the emphasis here is on “roughly” – the models used are sometimes called into question and must be revised from time to time.  And imputed spending on housing is a big number – probably around $1 trillion in today’s economy (with total GDP at about $15 trillion).

If an enterprising future administration wanted to lower spending relative to measured GDP, they could convene a panel of experts that could duly find that our current practice of not valuing household services – like cooking and taking care of children – is a statistical aberration as well as an affront to people who work very hard.  That should add at least $5 trillion to our annual GDP.  Alternatively, a statistical adjustment in the other direction would force real and painful spending cuts.  The constitution is the wrong place to pursue such details.

GDP is too fuzzy and imprecise of a measure, with too much estimation involved, to be enshrined in the constitution.  As an analogy, suppose we decided that we wanted to avoid the recent acrimonious debate over raising the debt-ceiling.  Suppose we thought too many Congresspeople acted too childishly.  Imagine if there were a proposal for a constitution amendment that required only “mature and intelligent ” adults “with an IQ above average” be allowed to run for Congress.  How would mature be defined?  How would it be measured?  We would make Congress dependent on a test, an IQ test, that itself is subject to revision and interpretation.  Later administrations would pressure psychologists to change the IQ test to satisfy the needs of their party.  The same happens if we enshrine GDP as a requirement in the Constitution.

In policy terms, the balanced budget amendment is a very bad idea. A balanced budget requirement forces the government to act pro-cyclically instead of counter-cyclically.  This means instead of fighting a recession, the government’s actions would make the recession worse.  Granted there are provisions in the amendment to waive the balanced budget requirement if GDP drops 10%, but keep in mind how severe that is.  The Great Recession/Financial Crisis of 2007-09 was only a 6% drop in GDP.  Government wouldn’t have been able to counter it.  The stimulus program, which was too small to trigger recovery but did successfully stop the free-fall, wouldn’t have happened until the crisis had indeed become as bad as the Great Depression.  A balanced budget amendment means a return to the old days before World War II when the U.S. routinely experienced severe depressions and financial crises. Again Simon Johnson:

.. sometimes it makes a great of sense to apply an economic stimulus to an economy in freefall.  One such moment was 1930 (and 1931 and 1932), when no stimulus was applied.  Other moments were 2008 and 2009; both President Bush and President Obama initiated stimulus packages.  When credit for and confidence in the private sector evaporates, do you really want the government sector to be forced to make quick cuts – or raise taxes?..

The second policy objection to this balanced budget amendment is that it is really a back-door attempt to circumvent democratic debate and decision-making.  The amendment proposes to limit government as part of the economy to 18%.  But why 18%?  Supporters claim that is what the U.S. has spent on average in recent decades.  But why is that the right number?  The size of government is a political, democratic choice that is up to the population at the time.  If today’s population wants a smaller government, they can elect politicians to do that.  And if some future generation should decide that 18% is not the right number, that maybe they want a different set of priorities and to devote a larger share of the nation’s resources to public goods, why shouldn’t they be able to do that?  Many nations devote a much higher % of GDP to public goods instead of private consumption goods.  Their economies are successful and their people are satisfied with it.  Having the current crop of legislators set a limit on what future generations may choose or do is not consistent with the concept of responsive democratic government.  It makes no more sense to enshrine an 18% limit on government spending in the constitution than it does to constitutionally enshrine a fixed limit on the number of soldiers the government may have.  It should be up to the representatives of each generation.

I’m not the only one who’s opposed to a balanced budget amendment.  And, the opposition isn’t all “Keynesian Democrats” (I don’t qualify as one of those either).  Simon Johnson, the author I’ve quoted above, is a former Chief Economist for the IMF.  The IMF has historically advocated and pushed for balanced budgets, yet it opposes this kind of handcuffs of economic policy.  Further, a Republican economist, Bruce Bartlett, has articulated many of these same problems with the amendment.

Possible Good News – A Gasoline Price Drop Would Help.

Ronald White of tthe LA Times brings us this nugget via CalculatedRiskBlog:

Since I haven’t posted on gasoline prices in some time … from Ronald White at the LA Times: Gas prices expected to fall

“If oil remains low, the national average for gasoline will fall to $3.25 to $3.40 in the next two to three weeks as retailers slowly lower their prices to reflect their drop in cost,” said Patrick DeHaan, senior energy analyst for GasBuddy.com, a website that lists retail gasoline prices.

Another price decline would be good news, but it just takes us back close to the late February and early March levels – and March is when Personal Consumption Expenditure (PCE) growth slowed, and consumer sentiment fell sharply.
If this comes to happen, then it raises the chances of avoiding another drop in GDP  and another recession.  It’s the first positive contingency I’ve seen for quite awhile.  Most of the “if this happens…” around today are all negative: Eurozone collapses, Bank of America hits more losses, state and local governments continue to layoff workers, etc.  Of course, gas prices dropping depends on oil prices staying down, and that depends on the big banks and hedge funds not speculating in the oil markets to drive them up.

Is Debt-to-GDP a Good Measure?

In a previous post, reader Sergei asks

Hello, I appreciate your article, however, I still wondering what is the meaning of the National Debt over GDP ratio? My numbers based on the US debt clock http://www.usdebtclock.org/index.htmlshow me that this ratio currently around 98%. Could you briefly explain what is the meaning behind this number?

Others might find the answer useful, so I’m making a post out of my response.

The “national debt” is the total money borrowed by the national government. It is the sum total of all the bonds and T-bills that have been issued and still outstanding by the U.S. government regardless of who owns (the lender or creditor) the bonds.  In some cases, one unit of the government such as Social Security owns the bonds which means in effect that one part of the government owes money to another part of the government.  In other cases, the central bank, The Federal Reserve, owns the bonds.  For details on the breakdown on the U.S. debt see here.

For centuries, nations have borrowed money and for centuries, there have been national governments that have found themselves unable to pay back the money or at times to even pay the interest on the money they borrowed.  These events are called “sovereign defaults”.   Economists are interested then in the is How much debt is too much?  Can the government bear the interest costs of the debt?  It is much the same kind of question that a bank asks about an individual when making a loan to an individual.  But there are important differences.

In doing this we are trying to compare the amount of debt to some measure of the government’s ability to make the payments.  The debt-to-GDP measure is simply a percentage number using total debt outstanding as the numerator and the size of GDP as the denominator.  We use GDP as a measure of the government’s ability to pay since a government’s income is taxes.  The taxes that can be collected depend on the total of all economic activity. After all, you can’t collect taxes of $1 trillion from an economy of only $500 billion, but it’s easily plausible to collect $1 trillion in taxes from an economy of $15 trillion. The higher GDP is, the more it is assumed the government has an ability to collect taxes and pay the interest.  Thus when the ratio is higher, it indicates that a lot of debt is outstanding and that implies (but only implies, not requires) a lot in interest payments.  So, it is assumed by many that a higher debt-to-GDP ratio means interest payments are likely a  greater burden and thus the chance of eventual default higher.

Using a debt-to-GDP ratio carries two major advantages over just using amounts of debt.  First, it allows us to compare two different countries regardless of their size.  For example, we can compare a small, little country like Greece which has a debt-to-GDP ratio that’s around 153% to a very large economy like say Germany which is around 84%.  Even though Greece has much, much less actual debt outstanding, it’s debt is a bigger burden on it than Germany’s debt is for Germany because Germany has a bigger economy and more ability to pay. Second, using the ratio allows us to compare debt levels of a country from different years.  Debt may be growing in dollar terms but becoming less of a burden because the country’s GDP is growing faster.  This was the experience of the U.S. since World War II.  In WWII debt-to-GDP reached 112%.  Ever since then, the U.S. has had an increasing debt because it almost always ran a budget deficit.  But the debt-to-GDP ratio declined from 1948-1981 because the economy grew so fast.

Why There’s So Much Attention to the Ratio In Recent Years

I’ll let noted economist Robert Shiller explain in his article in Japan Times (btw, this is an excellent, easy to read article – I recommend reading it):

A paper written last year by Carmen Reinhart and Kenneth Rogoff, called “Growth in a Time of Debt,” has been widely quoted for its analysis of 44 countries over 200 years, which found that when government debt exceeds 90 percent of GDP, countries suffer slower growth, losing about one percentage point on the annual rate.

One might be misled into thinking that, because 90 percent sounds awfully close to 100 percent, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90 percent figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30 percent, 30 to 60 percent, 60 to 90 percent, and over 90 percent.

And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category.

There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.

The Problems With the Ratio

One major problem with the ratio is that people misunderstand it, as Shiller explains.  Many people think that a ratio of over 100% means the country is insolvent or bankrupt.  That’s false and a fallacy.  Many mainstream economists claim to be uncomfortable with ratios of over 90%, but that’s purely an arbitrary pick that reflects ideology more than economic experience.  Japan, for example, has been running a ratio of well over 200% for a decade with no signs of default.  In fact, investors think the Japanese government and economy are solid enough that the Japanese government borrows money at the lowest interest rates in the world.

Another very serious problem with the ratio is that when the ratio goes up, people assume it is because of deficit spending and borrowing.  In reality, most times when ratios go up it is because a recession or austerity program has shrunken the size of the economy and GDP.  For example, since 2007 the U.S ratio has gone up a lot.  But most of the increase has been because of the decline in GDP, not because of the stimulus spending program.

Finally, the last problem with measure is the very idea that it measures likelihood of default.  The empirical data on the relationship is weak.  Most importantly, default really happens when the debt-to-GDP ratio goes up AND the country borrows in somebody else’s currency (like small developing nations) AND the country has either fixed exchange rates or a gold standard.  These conditions apply to those nations that are part of the Eurozone – the countries that use the Euro as their currency.  These conditions also apply to many smaller developing nations.  These conditions absolutely DO NOT APPLY to large developed nations with their own currencies such as the U.S., U.K., Canada, Japan, Australia, Switzerland, and many others.

So, overall, the ratio is actually a pretty poor measure.  It’s useful in some esoteric technical econometric studies, but as a guide to whether the nation should cutting spending or not, it’s a horrible measure.

For the reader who is curious, data comparing different countries debt-to-GDP ratios can be had from the CIA Factbook here.

Economicshelp.org offers some graphics comparing these concepts for the U.S. historically:

There are different ways of measuring US National debt.

Firstly, there is the actual value of debt. This shows that (even adjusted for inflation) the value of debt has increased significantly over the years

  • In 1900, US debt was $43.6bn (2005 prices)
  • In 1945, US debt was $2347.41 bn (2005 prices)
  • In 2010, US debt was $12032.28 bn (2005 prices)

Though there were a few periods in the 1920s, 1950s and 1960s when the real value of debt was actually being reduced.

gross debt / public debt

from: wikipedia US Debt

The Public debt is the US debt held by private sector.
Gross debt includes debt that the government holds itself.

 

We Have A Debt-Ceiling Deal. The Economy Loses.

Earlier this week the absurd and totally unnecessary debate in Washington over raising the national debt-ceiling came to an agreement, both houses of Congress passed it, and the President signed it.  Earlier this week I gave this metaphor for the deal, wondering why we need enemies with “friends” like our representatives in Washington.  Now that I’ve had a little more time to reflect, read some more on the details, comment on radio & TV about it, I think I was too easy on it.  It’s worse than it first appears.

This deal doesn’t “guarantee” that the U.S. government will reduce it’s deficit and maintain “solvency” (a non-concept for a sovereign country with a central bank).  Instead, this deal is more likely to guarantee that our economic non-recovery does, indeed, become at least a lost decade, if not a depression.  Right now I want to look at the economic impact of the deal.  In another post I’ll look at another casualty of the deal and the probably political-economy impact.

So what does the deal do specifically?  Well the details are fairly complex, even by Washington standards.  Right now the debt ceiling rises by $400 billion – enough to last for probably 3-4 months.  No real cuts will happen for maybe 60 more days.  Then starting in October 2011, which is the start of the government’s fiscal year 2012 budget (see here for definition of fiscal year), the action begins. Caps on spending start.  There are no tax or revenue changes in the deal.  It starts modestly with only $21 billion in spending cuts in 2012, although many of those cuts will be felt painfully by many citizens.  Students in graduate school in particular will feel the pinch in their pocket. Then in the remaining 9 years of the deal, there will be at least another $896 billion in reduced spending, amounting to about $100 billion less spending per year than currently planned.

This total of $917 billion in reduced spending is only the start though.  Congress is going to appoint a “special joint committee” of 12 members to recommend and additional $1.2-1.5 trillion in either spending cuts or tax revenue increases over the next 10 years.  (if you believe that committee with half Republicans will allow any revenue increases, I have a bridge in Brooklyn for sale).  If Congress doesn’t adopt those cuts, then Medicare payments, defense spending, and other discretionary spending would automatically by cut across the board. Either way spending gets cut another $1.2 trillion for the years 2013-2022.

This deal is supposed to raise the debt ceiling enough to get us through the end  of 2012 and the presidential election before the debt ceiling has to be raised again, sparing us this debate.  Don’t bet the your house on that though because House Republicans are betting they can keep this debate alive through then.  Basically Congress has created an elaborate mechanism in this law that increases the debt ceiling in several steps between now and the end of 2012.  But the way it’s done is that the debt ceiling keeps going up unless Congress votes to stop it (which the President would then veto).  It’s  a way for Republicans to keep talking about the debt and deficit, to keep recording “votes” against it, but all the time knowing that the debt ceiling will rise because it has to.  Pure politics at the expense of the country.

Right now the economy has over 9% unemployment.  Inflation is so low that deflation is actually the threat. The economy has effectively stalled or at least reached “stall speed”, threatening another double-dip recession.  This is not the time to be cutting spending.  To the degree spending cuts are necessary, they should happen when the economy is at or nearing full employment, not now.  At this time the economy needs all the spending it can find whether it’s from consumers, firms, or government.  And right now, firms and consumers are pulling back and keeping their wallets closed.  The government needs to step up and fill the gap.

So bottom-line, what should we expect?  I’ve seen several estimates from folks with more sophisticated econometric models than I can access.  My own back-of-the-envelope calculations and intuition say the drag on the economy is significant.  In 2012, this deal is probably going to take up to another 0.4 percentage points off of GDP growth.  The real damage starts in 2013 with a reduction closer to 1%.  Remember we’ve only grown at 0.8% rate so far in the first half of 2011, so 2012 will be close to zero growth and 2013 will likely be negative unless some other source of growth and spending can be found.  Looking around, it’s hard to imagine where that could be.  Instead I see nothing but possible negative risks: Europe imploding in a currency and austerity crisis, China having to pull back to slow their inflation, the housing mess in the U.S. is still bad, U.S. banks aren’t as healthy as they claim.

The estimates I’ve seen are similar.  Economic Policy Institute says the debt ceiling deal with cost us 1.8 million jobs in 2012 alone. The same article reports:

Top economists and CEO’s have also weighed in against the deal and said that GOP concessions to the Tea Party will cost our economy dearly. Pimco CEO Mohamed El-Erian warned that the deal will lead to less growth, more unemployment, and more inequality. Nobel Prize-winning economist Paul Krugman called the plan “a disaster” and “an abject surrender” that will “depress the economy even further.”

The Center for American Progress’s Michael Ettlinger and Michael Linden argue that while the deal “goes straight in the wrong direction,” Congress can redeem itself by using the so-called “super committee” mandated by the bill to focus on job creation. The committee, made up of six Republicans and six Democrats, is tasked with finding an additional $1.5 trillion of deficit reduction over the next 10 years, and must report a plan by Thanksgiving.

It’s noteworthy that J.P.Morgan Chase Bank’s research department, as representative of Wall Street as any, says that overall with this deal, government budget policy in 2012 subtract at least 1.5% points from GDP growth rate in 2012.  Since  it takes at least 2% growth in GDP to keep unemployment stable and we haven’t even had a single quarter of growth at more than a 4% rate since the end of 2006, things look grim for employment.

The cutters and austerians have won.  They will make a wasteland of the economy in the name of fighting the deficit.