Why Abrupt Government Budget Cuts Could Stall the Recovery

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Federal budget cuts could put the economic recovery at risk, according to a new Goldman Sachs report. There's no shortage of alarmism directed toward investors.

Slight upticks in the price of food or oil -- or even a garden-variety slowdown in the consolidation phase of an economic recovery -- are enough to set off howls of an imminent doubled-dip recession.

But ironically enough, real threats to the budding economic recovery often garner dismissive attitudes instead.

The hostile response to a recent report by investment bank Goldman Sachs (GS), which highlights the risk of a dramatic cut in government spending just as the economy gains momentum, is the latest case in point.

Modest Cuts, Big Potential Losses

The argument is straightforward enough. "Fiscal drag is quickly re-emerging 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," Goldman Sachs analysts wrote. "We see federal spending cuts as the most important near-term risk."

The analysts admitted that the proposed cuts were modest in size. They call for shaving off about $25 billion of spending in 2011 and $50 billion in 2012.

But the suddenness of the slashing could hit GDP growth hard in the near term, even if spending leveled off in the long run.

"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, 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 analysts wrote.

The British Example

Plenty of commentators viewed the report as a devious Goldman Sachs attempt to play politics and arm Democrats with talking points as the debate over government spending heats up. But investors would be wise to ignore the political rhetoric and look at the evidence instead.

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In the U.K., Prime Minister David Cameron also took a hawkish stance on spending and made deep cuts. While Cameron's tough talk was well received initially, the British economy lost major momentum as a result and is now on the brink of a second downturn.

The U.K. admittedly had far less room to maneuver than the U.S. does. Speculators were hammering the British pound in the wake of the European debt crisis, and a run on the currency was a real risk at the time. But in both countries, demand-destroying cutbacks could stall recovery at a critical juncture.

Indeed, there's evidence that cutbacks at the state and local levels already are having an outsize impact on U.S. economic growth.

Looking through the revised fourth quarter GDP data released Friday, TD Economics analysts noted that government consumption was notched down to minus 1.5% from minus 0.6%, with the revision focused at the state and local levels.

"This category tends to have a relatively small influence on GDP as a whole, but in today's release it did account for 0.2% percentage points of the downward revision in the GDP estimate," the analysts wrote.

Look Past Doomsday Scenarios

At a time when government spending is still picking up some of the slack left by still-dampened private demand, it's hardly shocking that government pullbacks are having a bigger impact then they would in ordinary times.

Over-the-top doomsday scenarios get plenty of attention. But investors should keep a closer eye on more measured arguments like Goldman's instead.

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