However you slice the data, the US economy struggled more than expected in Q4, led by a drop in defense spending
There are some, like Joe Weisenthal of Business Insider, who disagreed with my argument earlier about the responsibility of the fiscal cliff vacillation in Washington for the weak fourth-quarter performance of the US economy.
Joe, for instance, argues that the drop in business inventory was expected, and that businesses spent more money on software, which shows some measure of confidence despite the fiscal cliff. He calls worries about the fiscal cliff the result of the “Confidence Fairy”, which seems to bless certain economic outcomes with the alleged sparkledust of business confidence. But like Santa Claus, the Confidence Fairy is not real, according to Joe.
There are a couple of major problems with Joe’s argument that the fiscal cliff had no effect on GDP.
The first problem is that one of the biggest contributors to the drop in GDP was the huge drop in defense spending. There would have been no other reason for such a big drop except for the fiscal cliff. So, if nothing else, the fiscal cliff, by hurting defense spending, affected GDP by at least 1.3 percentage points. As RBC analysts wrote today:
“The slowing in overall GDP growth in Q4 largely resulted from a moderation in the pace of inventory building, weakness in net trade, and an outsized drop in the often volatile government defense component that may have reflected precautionary cuts ahead of the so-called fiscal cliff.”
Joe also maintains that business spending on equipment and software actually increased. This is true. That kind of spending jumped by 12.4% in the last three months of the year – “the third-biggest jump since the economic recovery started in the middle of 2009″, as the Wall Street Journal points out. Joe reasons businesses would not have spent that money unless they believed the economy would be good, so the fiscal cliff must have been a fake concern.
But that may be based on only a shallow reading of the numbers. I would say just the opposite: business spending is a false friend as far as measures of growth go. It does not predict confidence. Very often, it predicts that businesses do not trust consumer demand to rise, and that they plan to squeeze more out of existing workers.
Here’s how that works: Business spending started going up two years ago. The expectation was that businesses were investing in themselves to ramp up in response to greater demand for their products. That would eventually result in more hiring.
But business spending has not actually signalled greater demand or more hiring. Instead, it’s a sign that businesses are squeezing more work out of their workers. That means they have to update their machines or their software – often after years of putting it off. But it doesn’t trickle down to the rest of the economy – or at least, it hasn’t for nearly two years.
So I would respond to Joe by saying that business spending is not a sign of confidence – it’s a sign of the opposite, that businesses plan to continue squeezing more out of their workers without hiring more. Only when businesses really start to hire on a grand scale can we believe they believe that the economy is strong enough to support more demand for products from consumers. But business leaders have been complaining that the demand just isn’t there; that doesn’t appear to have changed, in their opinion.
Another way you can judge that the fiscal cliff definitely had an effect: Business investment in buildings fell by a significant amount – 1.1% in the fourth quarter alone. Any real estate investment requires a pretty good understanding of what tax rates will be. Since the fiscal cliff caused businesses to be completely unsure of what their tax rates would be, we can also attribute the drop in business investment in buildings to the fiscal cliff.
Lastly, Joe argues that the fiscal cliff was irrelevant because the drop in inventories was largely expected. That’s true about inventories, but it’s an issue of quantity. The inventory numbers were not expected to drop so low. In most economic numbers – as with company earnings – the major issue is not the drop; it’s the surprise of it. Was it expected? If so, it means that our understanding of the economy is on track. If not, it means there is a contradiction in our premises and there is a reason to dig deeper.
So it is with inventories. If inventories dropped by such a surprising amount, it doesn’t mean that retailers are selling more than expected; it means that they’re probably afraid to order more, because they’re worried about demand. What leads to this conclusion is that retail sales were not particularly good, except for Black Friday and Cyber Monday. People did most of their shopping early in the season and then didn’t keep spending.
You have to wonder why inventories dropped so much; you would need a shock of some sort to explain it. The fiscal cliff is one such shock; Hurricane Sandy could be another. But it’s very hard to argue that businesses were confident, based on that surprising plummet in inventories.
Joe also points to consumer spending as a signal that the fiscal cliff had little or not effect on the economy. This really doesn’t make a dent; consumers were largely unaware of the fiscal cliff and did not factor it into their thinking, according to numerous polls. The key to judging the effect of the fiscal cliff is to look at what businesses are thinking; they were the ones who were educated about the issues and who have any kind of control over the levers that move the economy.
Consumers showed evident fatigue about Washington’s reindeer games and just went about their business; their behavior is largely divorced from the fiscal cliff debate of last year. (Though it is likely that consumers will react to the increase in the payroll tax this year; it’s less money in their paychecks.)
Another issue that Joe brings up in support of his point against the fiscal cliff is another, separate measure: durable goods orders. These are big, heavy items, and when those orders rise, it’s generally a good sign for the economy. Orders jumped by 4.6% in December, which is significant.
But this number, too, is misleading. As the Wall Street Journal notes, the rise in durable goods was not because businesses were suddenly full of confidence. Instead, “the rise was fueled by stepped-up spending on aircraft and defense products, two volatile categories that can obscure the real picture.” In fact, if you take out transportation equipment, the Journal notes, durable goods order rose only 1.3%. That’s good news, but hardly a sign of business confidence going gangbusters.
The fiscal cliff certainly put a dent in the economic numbers, at least for the fourth quarter. It certainly did not help them. Confidence does not come in fairy form, but it does count, because human beings are not automatons. The biggest mistake economists make is to assume that all decisions are economically rational; we know that for a fact to be untrue, though. People make irrational decisions, and some of those people are CEOs. If they feel fear, they won’t spend money. In fact, that is the threat that CEOs have been making for years in response to Washington policy and regulation.
The fact is, that there are very few economists who would dismiss the effect of the fiscal cliff out of hand. The economy clearly received a shock in the fourth quarter. Polina Vlasenko, a research fellow at the American Institute for Economic Research, noted that the fiscal cliff was one of the factors holding back the economy in the fourth quarter, enough to require a recovery:
“As the economy recovers from the effects of Sandy and the fiscal impasse in Washington, we expect to see a rebound in growth in the first quarter of 2013. This forecast is supported by the fact that consumer spending, the main driver of the US economy, continues to grow steadily.”
The Confidence Fairy does not exist. But what does exist is the very real effect of Washington policy changes on very real taxes and very real government spending. Washington was talking about extreme, tangible changes worth hundreds of billions of dollars.
Any CEO or business owner who would have ignored that and blithely continued to spend would have been an impractical business person. There is no sparkle dust that will distort that reality.