Goldman Sachs: House Spending Cuts Will Hurt Economic Growth(Keynesian gloom and doom)

A confidential new report prepared by Goldman Sachs for its clients says spending cuts passed by the House of Representatives last week would be a drag on the economy, cutting economic growth by about two percent of GDP.

“Under the House passed spending bill [which cut spending by $61 billion],” says the report, which was obtained by ABC News, “the drag on GDP growth from federal fiscal policy would increase by 1.5pp to 2pp in Q2 and Q3 compared with current law.”

The report, which is signed by Goldman economist Alec Phillips, goes on to predict that the House-passed bill is unlikely to become law because it won’t pass the Senate and, in any case, the president threatened to veto it.

More likely, the report says, is a deal to cut spending by $25 billion this year, followed by a cut of $50 billion next year.

Even those more modest spending cuts, Goldman Sachs predicts, will cut economic growth rates by one percent of GDP.

•Proposals to cut federal spending, the possibility of a government shutdown, and the escalated debate over state employee compensation has increased interest in the effect of fiscal policy on growth, after last year’s fiscal package briefly neutralized the expected drag from federal fiscal policy. •Federal spending cuts deserve the most attention. They are the most likely of these issues to occur, and could have the largest magnitude. The assumption we incorporated into our recently revised budget estimates—discretionary spending cuts of $25bn and $50bn below the CBO baseline for FY2011 and FY2012 respectively—would shave nearly one percentage point off of the annualized rate of real GDP growth in Q2, but would fade quickly with a negligible effect on growth by year-end. •The related risk of a temporary federal government shutdown could also lead to a fiscal drag on growth, but this appears to be a lower probability scenario. We estimate that each week that the federal government is shut down would reduce federal spending by around $8bn, and could reduce real GDP growth by as much as 0.8 pp at an annualized rate in the quarter it occurred, but would provide a lift to growth in the following quarter as federal activity returned to the previous level. •The policies that several state governments are debating related to state employee compensation and organization appear to have—at least in the short term—little potential macroeconomic effect. We assume that state governments will cut spending or raise taxes no more than necessary to balance their budgets. This amount will be determined by the level of tax receipts available to pay for spending, not political negotiations. Fiscal drag is quickly reemerging as a focus, only a couple of months after an agreement to extend tax cuts and unemployment benefits appeared to have neutralized most of the drag from federal fiscal policy for most of 2011. We see federal spending cuts as the most important near-term risk. The possibility of a government shutdown is a significant but less likely factor, while the debate over state employee compensation seems unlikely to have a meaningful near-term macroeconomic effect:

Federal spending cuts would result in additional fiscal drag: In our recently updated budget deficit estimates, we have assumed that Congress will reduce discretionary spending by $25bn below the Congressional Budget Office's (CBO) baseline for FY2011, and another $25bn (for a total of $50bn below the baseline) for FY2012 (for more on these assumptions and our budget estimates, see “The US Budget Outlook: Better, but Not Good Enough,” US Economics Analyst 11/05, February 4, 2011). By contrast, the House of Representatives passed legislation over the weekend to cut spending for FY2011 by $60bn from current levels (the House hasn’t yet addressed FY2012). Both scenarios would add to the drag from federal fiscal policy on growth:

•The modest spending cuts we assume in our own budget forecast would lead to renewed fiscal drag. Since spending cuts could be enacted no earlier than next month, when the current fiscal year will be nearly half over, $25bn in cuts would require spending in the second half of FY2011 to be reduced by $50bn at an annual rate. Since the cut would be phased in abruptly, it could result in a drag on growth in Q2 by as much as one percentage point (pp), but would quickly fade over the next two quarters as spending stabilizes at a lower level, with little effect versus current policy on the rate of real GDP growth by year end. •The spending cut package that passed the House of Representatives would have a deeper effect. Under the House passed spending bill, the drag on GDP growth from federal fiscal policy would increase by 1.5pp to 2pp in Q2 and Q3 compared with current law. However, we don’t see this scenario as likely; while we expect discretionary spending to be cut, the current House proposal doesn’t appear viable in the Senate, and the president has already threatened a veto.

A federal shutdown poses less risk, as long as it is brief: A federal shutdown can potentially occur when one or more of the 12 annual appropriations bills have not been enacted for the current fiscal year. Usually, Congress provides temporary funding through a “continuing resolution” (CR) until appropriations have been enacted, but from time to time, particularly when control of government is divided, this does not happen and funding lapses. When this occurs, any agency or cabinet department without funding in place for the current fiscal year must cease non-essential operations. So far, Congress has not enacted any of the annual appropriations bills for the fiscal year that began October 1, so a shutdown would affect virtually all non-essential programs. That said, the potential for a federal shutdown probably does not present a major risk:

•While the possibility of a shutdown is real, it isn’t that likely. We wrote more extensively on the key fiscal developments over the next few months last week (see “The Federal Budget Process Gets Underway,” US Daily, February 17, 2011). The bottom line is that while rhetoric has escalated regarding spending cuts and the threat of a shutdown, we expect both sides to try to avoid one if possible, with the most likely solution appearing to be a short-term extension of funding at slightly reduced levels. •The effect of a shutdown is narrower than the term implies. Even in the most protracted government shutdown to date, from November 13 to 19, 1995 and again from December 15, 1995 to January 6, 1996, the majority of federal employees kept working. In the first episode in November 1995, about 40% of federal employees excluding the postal service were furloughed; in the December lapse the share of furloughed employees dropped to less than 15%, since Congress had managed to enact some appropriations legislation between the two shutdowns. If a shutdown occurred next month, it would probably affect nearly all agencies and departments, since no appropriations legislation has been enacted so far this year. But even so, this would imply that only around 40% of federal employees would be affected. •A shutdown lasting more than a week could be meaningful. If Congress fails to renew the continuing resolution that is set to expire on March 4, the lapse seems likely to be fairly short. After all, there have been several short government shutdowns over the last few decades, but only two lasting more than three days. But a lapse of more than a few days, particularly toward the end of the quarter, could be more important. If funding lapsed, non-essential services would shut down immediately, representing around $8bn per week in missed federal spending, assuming that 40% of federal employees (not including the postal service) and their activities are deemed non-essential. This would equate to $32bn in annualized terms, or around 0.2% of GDP for each week of shutdown. Pulling this spending out of Q2 would reduce the contribution to quarterly GDP growth from federal activity by a little over 0.8pp at an annualized rate for each week the shutdown lasted, though if the shutdown ended long enough before the end of the quarter it is quite possible that some of the missed activity could be made up, reducing the overall hit to growth. Otherwise, the return to previous spending levels following a one-week shutdown would actually increase growth in the following quarter by 0.5pp and by smaller amounts in subsequent quarters until most of the effect is reversed.

State budget negotiations seem likely to have the least effect: Debate over state employee compensation and the related issue of collective bargaining and other organizational issues among state employee unions have begun to make headlines in a number of states—Wisconsin, Ohio, and Indiana are the latest. While these issues are important for the longer-run fiscal health of state and local governments, in the short-term their balanced budget requirements make revenue shortfalls the most important factor driving their fiscal stance over the coming fiscal year (for most states, this begins in July). Political decisions will determine how spending cuts are distributed, and will also determine the mix of tax hikes and spending cuts, but are much less likely to change the overall amount of tightening that will occur. So while we continue to expect around 0.5pp in drag this year from state and local fiscal retrenchment, recent developments don’t seem likely to change this in either direction.

Thank you very much for your reply, it was a great pleasure to read it. You have passions and convictions like all others but you keep an open mind. I very much respect you for your open-mindedness and intellectual honesty.

But when I see things like this about a global corporation and its influence with government here, I get concerned. I am with you here. I get concerned whenever I see power -- it is used properly, by whom, to what ends? It's an American tradition to keep an eye on those in power, right? A fair appraisal of these concerns and Goldman Sachs in terms the layman can understand would be appreciated.

I would be most happy to share with you whatever I know myself. However, there is so much garbage said about GS (see the reason below) that it makes sense to do it point by point (accusation by accusation), if you care to do so. So if there is something specific, please tell me, and I'd be glad to respond.

There are only two general observations I can make at the moment. 1. Some people look at coincidences and read too much into it (if you are familiar with the term, I refer to spurious correlation; if not, please ignore it). Look at all those hot shots at GS who somehow become hotshots in government! There must be a reason for that, they conclude -- a nefarious reason.

There is a reason: Goldman has the culture of attracting the best talent, the generosity to retain it by generous pay, and wisdom to leave it free so that the talent can mature and grow. While it takes considerable amount of brains and other qualities to make it anywhere on Wall Street, Goldman hunts for and gets the best of the best. That is why it is hated even by the rest of the Wall Street. Somehow Goldman gets it right when the rest do not --- and who would like that for long?

Incidentally, this happened again in the last crisis, which hit in October of 2007. I heard a story, according which a low-level analyst became alarmed in the preceding May about the risk in the housing market. In any other corporation, not even on a more horizontal Wall Street, he would not even be heard, but brains and ability are respected at Goldman. This guy got the ear of the most senior management. Having been persuaded, senior management changed course and worked on reducing risk in general and the exposure to (dealings in) the housing market. As a result, when the crisis hit in October, GS was the only banks that was in quite decent shape. Once again, somehow, they were the only ones that got it right.

This envy of the rest of the Wall Street is what often drives articles in Seeking Alpha. That website has many purely scientific, honest articles on finance. But it also became the outlet for the wannabes that did not make it, those that probably wanted to work for GS but did not get an interview. So they write complete garbage as long as it attacks their two favorite targets: Goldman Sachs and the Fed. They think it makes them look smart: if I attack big shots, it make me even bigger. To be fair, those articles may be full of details that are correct and true, but their conclusions are almost always incorrect (a loan officer may know a great deal of how loans are originated, recorded, sold, etc. but still no clue what role mortgages play in the economy --- economics is needed for that; a mechanic may know a great deal about cars but still not know why it works --- physics and engineering are needed for that; so is with finance).

Why am I telling you that? Because some socialist-minded "conservatives" on this forum --- Blam and fromLauri, for instance --- made a career of posting that garbage here on FR --- from Seeking Alpha or the outright leftist sources such as Guardian and Reuters. I very much understand your position: here is an article from Seeking Alpha, say, written by a finance professional, which tells me that GS lies, steals, and manipulates the government; and the Fed is just plain stupid and corrupt (remember, it is a private organization to begin with --- horror, horror!). Why should you not believe them? And how can you remain unconcerned?

Well some envious people at Seeking Alpha and the rest of Wall Street have their reason for attacking GS. But that is a minor problem. Much bigger problem is this:

2. Attack on Goldman is the boringly the same tactic that the left used for over a century to undermine capitalism. Even Marx understood, that to entice your anger, he must concentrate on finance. Since then, all socialists did that: Roosevelt, Mussolini, Hitler, Lenin and his followers in Russia. They all did that. There was only one change in that tactic that I am aware of: Hitler wanted his followers to be angry at Jewish financiers ("They started WW I to make profits on the backs of the German volks," "They made us lose WW I because it was profitable for them," etc.). But that was minor: German people "knew" very well that all financiers are Jews and all Jews are rich. So words "financier" and "Jew" were synonymous in in Germany but not elsewhere (not even in Italy, as far as I know). Other than this detail, the attack on the finance sector as a symbol of capitalism is a constant, invariable strategy of the left" in all times and all countries.

It works because it is easy. How can you be mad at Alcoa? When you think of it, you think of the workers at alumina-making plants, real people who work hard to feed their families. They produce products to which you can relate even if you are not a metallurgy engineer: you know that aluminum goes into cars and probably other machinery. How can you be mad at Alcoa? If anything, you'd probably sympathize if it falls onto hard times.

Compare that with Goldman. You've seen only two images on TV. The first is a huge, somewhat scary building, invariably shown with the camera panning from the entrance in midtown Manhattan upwards to the sky --- this leaves you with a feeling of huge but unknown power wielded by GS. The second is a row of twenty-somethings sittings on a large open floor and staring at the terminals. What do these people do? Seems like nothing. Seems like they are manipulate something (numbers, markets). Instead of producing something useful, they basically take a portion of what other people produced, don't they? Those bloodsuckers! And, just look at those bonuses -- how can you justify that?

When was the last time, if ever, that you've heard anything about these people as human? How many of us know that investment bankers work 110-120 hour weeks; that sometimes they don't come home for days in a row, showering at work and napping at the desk; that nobody remembers anyone taking a week of vacation... Most people would not want those bonuses at thatprice, they may even feel sorry for those rich bankers who money and stay and great hotels but have no personal life and don't see their kids. The media will never tell us. I have never heard on TV and never read in the press anything human said about investment bankers. Have you?

It has always been easy to sell this garbage to an average Joe and Jane who do not know what finance is and what good finance does for society. That is why, whenever a crisis occurred in the past 150 years, finance was the first to be attacked by the socialist. That is why it is so difficult for an honest person like you: you hear a barrage of terrible things about GS and Fed --- how can most of it be false? It can and always was.

I will have not yet but will read the articles to which you posted links and try to respond. In the meantime, if you see a post that you want to ping me on, please do so, OK. I'll also look for the links to some recent posts.

Best, TQ.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.