The US government shutdown may be worse for the economy than you think

Key Concepts

Government Shutdown: A situation where non-essential government operations cease due to a failure to pass appropriations bills.
GDP (Gross Domestic Product): The total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.
Consumer Demand: The desire of consumers to purchase goods and services.
Contractual Obligations: Agreements that bind parties to perform certain actions or make payments.
Economic Damage: Negative impacts on an economy, such as reduced growth, job losses, or decreased investment.
Recoverable vs. Unrecoverable Economic Activity: Economic activities that can be made up after a disruption versus those that are permanently lost.
CBO (Congressional Budget Office): An independent federal agency that provides economic forecasts and analyses of budgetary and economic issues.
Fiscal Challenges: Difficulties related to a government's finances, including debt and deficits.
Debt-to-GDP Ratio: A measure of a country's debt relative to its economic output.
Inflation: A general increase in prices and fall in the purchasing value of money.
Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.
Dual Mandates of the Fed: The Federal Reserve's objectives of maximizing employment and maintaining stable prices.
K-Shaped Economy: An economy that is bifurcated, with different segments experiencing vastly different outcomes (e.g., high-income earners doing well, while low-income earners struggle).
Basis Points: A unit of measure used in finance to describe the change in value of financial instruments. One basis point is equal to 0.01% or 1/100th of a percent.

Economic Impact of the Government Shutdown

Duration and Severity

The current government shutdown is characterized by its unprecedented length, making it the longest in US history. This extended duration is a primary driver of its significant economic damage. Daniel Alman, an economist and author of the High Yield Economics newsletter, posits that this shutdown could be the most economically damaging in US history due to its length and the dynamics it creates between consumers, the government, and government contractors.

Impact on Consumers and Demand

Federal Workers' Uncertainty: A substantial number of federal workers are uncertain about receiving back pay for the shutdown period. This uncertainty acts as a drag on consumer demand as individuals may reduce spending due to financial insecurity.
Government Contractors: Companies that do business with the government are also not being paid. If this continues for an extended period, it can significantly impact their operations and ability to pay their own employees, further affecting consumer demand.

Potential GDP Impact

Alman estimates that if the government fails to pay its contractual obligations for six weeks, it could result in a 2% drop in Gross Domestic Product (GDP). This level of decline could potentially wipe out the entire year's economic growth. While he clarifies that a 2% drop is the maximum potential impact, it highlights the severity of the situation.

Unrecoverable Economic Activity

A key differentiator of this shutdown is the loss of economic activity that cannot be recovered. Unlike shorter shutdowns where postponed activities are typically caught up later, this prolonged shutdown leads to permanent losses.

Cancelled Flights: Flights that are cancelled due to the shutdown are flights that will never be flown again, representing lost revenue for airlines unless they can compensate by increasing prices on other flights.
Licensing and Permitting: Delays in licensing and permitting processes hinder trade and commerce. For instance, goods may not be cleared from ports in a timely manner because relevant government offices are closed, leading to lost business opportunities.

Contrasting Perspectives on Economic Impact

While Alman emphasizes the significant and potentially unrecoverable economic damage, the Congressional Budget Office (CBO) offers a more tempered view. A report cited suggests that the CBO reckons the economy will be "a bit worse off but not in a way that will be all that noticeable." They believe a shutdown of this magnitude is "unlikely to leave much of a mark."

Alman counters this by highlighting the pervasive uncertainty in the economy, affecting both consumers and businesses. This uncertainty has not only postponed purchases but has also dampened overall demand. He points to the period of stabilization hoped for in late August/early September, which was disrupted by renewed tariff news and the shutdown, effectively raising economic tensions again. This prolonged uncertainty, he argues, will have long-term negative effects on the economy as it forces businesses and consumers to remain on guard.

Root Causes and Fiscal Challenges

Self-Inflicted Wound

Alman describes the shutdown as a "self-inflicted wound" tied to the nation's debt and deficits. He identifies the core fiscal challenges as well-known.

Policy Responses to Fiscal Challenges

As an economist, Alman outlines three primary policy options to address fiscal challenges:

Raise Taxes: Increasing government revenue through taxation.
Cut Spending: Reducing government expenditures.
Inflate Away Debt: Using inflation to devalue existing debt.

The Bind of Fiscal Policy

Alman notes that the US is not adept at either cutting spending or raising taxes effectively. Regarding inflating away debt, he calculates that an annual inflation rate of approximately 4% for 20-30 years would be required. This level of inflation is undesirable and unlikely to be supported by the Federal Reserve. Consequently, the US is in a difficult position.

Shutdowns as Painful Belt-Tightening

Alman suggests that government shutdowns are a manifestation of the "painful belt-tightening" that is necessary but politically unpopular. He draws parallels to other countries like the UK, Spain, and France, which are also grappling with similar fiscal issues. He stresses the need for the US to undertake this "hard work."

Impact on the Federal Reserve

Flying Blind

The government shutdown significantly impacts the Federal Reserve's ability to gather crucial economic data. Both the Fed and other economists are described as "flying blind" due to the lack of official government statistics. While private sector data sources (e.g., ADP, Revelio Labs for employment, Chicago Fed for nowcasts) provide some insights, the prolonged shutdown creates a growing detachment between expectations and reality.

Dual Mandates in Jeopardy

This lack of data is particularly dangerous for the Fed, which operates under dual mandates of stable prices and maximizing employment. The shutdown creates the worst possible environment for them to make informed policy decisions.

Latest Developments and Market Reactions

Senate Passage and House Vote

The Senate has passed a temporary funding measure to reopen the government, with eight Democrats joining Republicans. However, Senator Rand Paul defected. The bill now moves to the House, where Speaker Johnson is scheduling a vote. The expectation is that the government could reopen by Thursday or Friday, with the shutdown lasting approximately six weeks. President Trump has indicated he will sign the bill.

CBO Projections for GDP

The CBO estimated that a six-week shutdown would result in a 1.5% hit to GDP in the fourth quarter, followed by a rebound to 2.2% in the first quarter.

Data Lag and Economic Fog

Beyond the GDP impact, the shutdown has led to a lack of major official government data, which investors and the Federal Reserve rely on. While the September jobs report, collected before the shutdown, is expected soon, it will likely appear "stale." The collection and release of new data will take time, leaving the economic picture "foggy" for a period.

Market Surprise and Consumer Psychology

Lou, a market commentator, expresses surprise at how long the shutdown has lasted and how markets have continued to trend higher. He notes that markets typically treat shutdowns as "political theater" with minimal long-term impact. However, this shutdown has transitioned from "K Street to Main Street," raising concerns about its effect on consumer psychology. The sight of Americans working without pay and the potential disruption of other government services could hinder economic growth.

Ripple Effects on Businesses

Lou is closely watching for ripple effects, mentioning that fast-casual restaurants like Chipotle are struggling. He questions if the consumer is reaching a breaking point. Despite these concerns, he emphasizes that he trades based on earnings and cash flows, which have been strong during the current earnings season, creating market opportunities.

Consumer Resilience and Fed Rate Cuts

The discussion touches on the risk of negative data impacting the market, which is currently at record highs. The prevailing sentiment is that the market is banking on the Fed cutting interest rates in response to weak data. Lou anticipates another 25 basis point cut, with some suggesting a 50 basis point cut in December, though he finds that less likely. He believes the Fed will continue its trend of easing, supporting consumer spending. Historically, the consumer has shown surprising resilience, with only two periods of quarter-over-quarter declines in spending (during the financial crisis and COVID-19). The current situation is being monitored to see if it represents an anomaly.

K-Shaped Economy and Healthcare Premiums

Jen adds to Lou's point by highlighting the ongoing lack of a deal on healthcare premiums, even with the government reopening. She reiterates the concept of a "K-shaped economy," where higher-income consumers are thriving, but middle to lower-income consumers are struggling. An increase in healthcare premiums for this segment will further pressure consumer spending, which has been a stabilizing factor. This, she suggests, is another potential ripple effect from the government shutdown.