Saturday, April 9, 2011

Macroeconomic Impact of the Budget Deal: Very Quick Estimate

In the e-mail age, there aren't as many envelopes lying around to do calculations on the back of, but I've nonetheless managed to do some rough figurin':

Last night's deal on the budget cuts $37.8 billion in spending.  I haven't seen the exact composition yet, but most of it is presumably "domestic discretionary spending" - i.e., the stuff that counts as government purchases in the national income accounts.

Generally we do our macroeconomic calculations at 'annual rates', and since there is about six months left in the fiscal year covered by the budget (i.e., the government budgets start in October), the cut is $75.6 billion at an annual rate.  The most recent GDP estimate is an annual rate of $14,871 billion for the fourth quarter of 2010, so lets call it $15,350 billion for the second third quarters of 2011 (based on roughly 5% nominal GDP growth, consistent with FOMC members' forecasts); that implies the cuts are 0.5% of GDP at an annual rate.

If we put the multiplier at 1.75, which is the midpoint of the CBO's range of estimates, the cuts reduce GDP by 0.875% at an annual rate.  The rule of thumb known as Okun's law says that, for every percentage point less of GDP growth, the unemployment rate increases half a percentage point.  So, over the course of a year, that would put unemployment at 0.4375 higher.  Since this is over six months, we're talking about an 0.22 point increase in the unemployment rate.  On a labor force of 153.4 million, that translates to a loss of 337,500 jobs.

Like Ezra Klein says, 2011 is not 1995:
Right now, the economy is weak. Giving into austerity will weaken it further, or at least delay recovery for longer. And if Obama does not get a recovery, then he will not be a successful president, no matter how hard he works to claim Boehner’s successes as his own. Clinton’s speeches were persuasive because the labor market did a lot of his talking for him. But when unemployment is stuck at eight percent, there’s no such thing as a great communicator.
A more conservative multiplier estimate of 1 implies a job loss of about 191,750.

The macroeconomic argument for a positive effect from such a deal would rely on the idea that deficit reduction improves confidence in the future.  In particular, if the government's future borrowing needs are reduced, there would be less "crowding out" of investment, and if future taxes are reduced, then lifetime disposable income has increased, which would generate higher consumption today.  I don't think either of those are relevant to a short-term budget deal when there is significant slack in the economy.  However, since many Americans seem to erroneously believe that government spending is hurting the economy, perhaps they will also think this is good for it.  Confidence, even for the wrong reasons, matters...

Not much has been said about the composition of the cuts, but I suspect they will be uglier than people realize.  While $38 billion sounds small relative to some of the numbers that get thrown around in budget discussions, it is quite significant relative to "nondefense discretionary spending" - i.e., what people usually think of as "the federal government" (see this previous post).

Update (4/14): Maybe not so bad.  It appears that the actual cuts are significantly smaller - apparently a significant portion of the $38.5 billion in "budget authority" being cut is money that probably wouldn't have been spent this year anyway.


Anonymous said...

Well, hell...

Anonymous said...

With unemployment high and the Republicans likely taking credit for any deficit reductions, the Republicans will have succeeded in making Obama a one term president.

Maybe we need another six years of Republican rule to remind us of how bad things can be.

Mark A. Sadowski said...

With all due respect this post reveals a little bit of fiscal stimulus innumeracy. It's better to think things through in levels and convert to rates later (if necessary).

Let's ignore the fact that most major models have their fiscal multipliers increase over time and peaking about 8 quarters after implementation. Let's instead, for the sake of simplicity, assume the effects occur instantaneously and that the fiscal multiplier is 1.75.

Then on a level basis real GDP will be reduced by 0.875% in the second and third quarter contrapositive. That won't impact the real GDP growth rate in the 3rd quarter (it will have already fallen in the second quarter) but it would reduce the growth rate of GDP in the second quarter by 2.0%, not 0.5% (a quarter's level change at an annual rate).

How much would it impact unemployment? Well a 0.875% reduction in level GDP should raise unemployment by 0.4375 points assuming an Okun's multiplier of 2. And that comes to a level job loss of about 675,000.

Now, all of this also assumes no reaction by the Federal Reserve which these days, given ZIRP, is somewhat hard to measure.

Also, I would argue, although the macroeconomic effects likely are going to be modest, they wont be if you're one of the (low income) people targeted by these deep cuts to discretionary spending, in which case they'll be gnourmous.

So I have no quarrel with your larger point, just your math.

Mark A. Sadowski said...

"...but it would reduce the growth rate of GDP in the second quarter by 2.0%, not 0.5%.."

should read

"....but it would reduce the growth rate of GDP in the second quarter by 3.5%, not 0.875%..."

Bill C said...

Thanks for the comments.

Mark - My calculation was based on the definition that Okun's law relates the change in the unemployment rate in a one-year period to the change in real output in a year. The impact, 1.75 x $37.8 billion, is 0.43% of a year's GDP.

I completely agree that 1.75 is a simplistic multiplier and the effect depends on circumstances - if anything, the zero lower bound makes it larger - this is where the "very quick estimate" part comes in.