US economic backsliding temporary? Maybe not if 'sequester' hits.

A dip in GDP during the fourth quarter of 2012 stemmed largely from a dive in federal defense spending. Some economists see a cautionary lesson for upcoming sequester talks in Congress.

By , Staff writer

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    An Abrams tank is built in Lima, Ohio. The US economy shrank in the fourth quarter of 2012, and a drop in defense spending was a major reason.
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When the government reported Wednesday that the economy shrank in the most recent quarter, forecasters generally said not to worry. This was a temporary slowdown, driven by one-time factors.

Defense spending fell by an unexpectedly large amount, and a decline in business inventories put some manufacturing activity on hold. The major storm named Sandy probably played a role as well.

But that assessment comes with an asterisk – one that Americans including members of Congress may want to heed. Some of the “temporary” setbacks could easily resurface if Congress doesn’t do a careful job dealing with partisan conflicts over federal spending.

Recommended: How much do you know about US entitlement programs? Take our quiz.

It’s not unthinkable that economic growth could turn negative for a couple of quarters – one definition of a recession – if the automatic spending cuts known as the “sequester” take effect as currently scheduled on March 1.

“The concern is valid,” says Rajeev Dhawan, who directs the economic forecasting center at Georgia State University in Atlanta. “Yesterday's headline number [puts] pressure on the Congress to come to some kind of a solution on the sequester.”

Consider that economists are generally forecasting growth of about 2 percent in gross domestic product this year, and in the fourth quarter a $47 billion decline in defense spending was, by itself, sufficient to drag down the rate of GDP growth by nearly 1.3 percent.

When the economy “paused” (that’s the word the Federal Reserve used Wednesday), planners in private businesses and at the Pentagon caused the downshift partly in response to uncertainty about the “fiscal cliff,” the scheduled tax hikes and spending cuts that loomed at the time.

The tax side of that uncertainty has been largely addressed, but the spending cuts were merely postponed until the end of February.

Both Democrats and Republicans have said they’d like to address federal budget deficits through planned adjustments, rather than the automatic cuts – which would be divided equally between defense spending and a large swath of non-defense programs.

Budget experts tout the idea of a bipartisan accord, for example, that would focus on reforming entitlement programs, while dealing a less-severe hit to the economy in the form of sudden spending cuts. It’s far from clear, however, that the automatic spending cuts will be avoided.

To many Republicans, willingness to let the sequester go into effect represents an important bargaining chip, as they seek leverage in talks with President Obama and Democrats wary of spending cuts.

Some economists say the economy, weak as it remains, could withstand the spending cuts contained in the sequester without entering recession. But they generally agree that the cuts, designed to total about $100 billion a year, would represent a substantial blow.

Economists at Goldman Sachs, for instance, are forecasting GDP growth of 2 percent in 2013, matching the average of forecasters surveyed monthly by Blue Chip Economic Indicators in Kansas City.

Jan Hatzius, Goldman’s chief economist, says that if the sequester takes effect, it would be harder for the economy to accelerate later this year, “and we would probably reduce our GDP numbers” for the year’s final three quarters to about 1.5 percent annualized growth, or a bit worse.

That would be a very disappointing growth rate, raising the prospect of continuing high unemployment. But if that forecast is correct, the US would avoid recession.

This week’s GDP surprise (economists hadn’t been expecting growth to turn negative) prompted both Republicans and Democrats to lament policy failures in Washington.

Where many Democrats warn that a Republican focus on spending cuts could choke the economy, Republicans generally say that a show of long-term budget discipline could help invigorate private-sector confidence and job creation.

Both those views may have important grains of truth.

The latest GDP news shows that with a growing private sector, the economy can handle a certain amount of fiscal restraint or austerity, but not an unlimited amount without causing a recession.

At the same time, economists generally say the need for fiscal discipline in the medium and longer term is real – and that the economy could be helped right now by putting changes in place.

Mr. Dhawan says the big need is for entitlement reform, more than for cuts in other government operations such as defense or scientific research. The question is whether the economic risks – apparent in the GDP headlines – will hold bargainers’ feet to the fire, resulting in a prudent fiscal plan.

“If that happens, to me 2014 looks very good,” and 2013 would look recession-free, he says.

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