How US Shutdown Will Affect the Economy

The overall consensus is that the US government shutdown will not affect the economy in the long run, with the rationale behind this decision being that the state will reimburse workers for their lost salaries. Hence, the idea is that so long as salaries are paid, even with a significant delay, the disproportionate reduction in spending as a result of the shutdown will be compensated by a disproportionate increase in spending once the money is returned.

However, this is not always be the case. For example, if a shutdown lasts only for a week or two, that week’s spending can be postponed, and the negative effect from week 1 will be erased by the positive effect from week 2 having a zero overall effect on growth. A household’s ability to transfer consumption to the next period starts becoming more difficult as the shutdown’s duration increases.

While shopping for food can be postponed for a week, or a household can purchase 60% of the usual amount of goods it needs for a week and then make up for it by spending 140% next week, uncertainty regarding the end date of the shutdown would make the household spend 60% of its usual levels until further notice. The issue with a long-duration shutdown is that the household will not really make up for its lost consumption, because it no longer serves any purpose.

In a more illustrative example, if a household usually purchased 2 kilograms of rice per week before the shutdown, it could reduce to purchasing 1 kilogram during the shutdown. Suppose that the shutdown lasts for four weeks: during that period, the household would normally have purchased 8 kilograms of rice, however, as a result of the shutdown it only purchases 4 kilograms of rice. Now suppose that the shutdown ends. What would the household do after all of its money has been returned to it? Naturally, it would revert to purchasing 2 kilograms of rice per week, maybe buy an extra kilo the first week just to celebrate. Would it make any sense to purchase the additional 4 kilos it has foregone? Not really, as it wouldn’t have a use for it: even if the household went all out and purchased double its normal quantity of goods in the first week after the government shutdown ended, it would have to revert to its previous level of purchasing for the simple reason that they would have no space and nobody would be able to eat the food!

The same would hold for the consumption of services: if someone went out for a drink once a week before the shutdown, and reduced it to zero during the shutdown period, it does not follow that this person will start drinking every day after the shutdown ended, just to compensate for the lost weeks.

Interestingly, the longer the shutdown lasts, the more permanent the effect could be on spending behaviour: if the above household now feels that 1 kilogram of rice is sufficient and 2 kilos had been excessive, then a permanent reduction in the quantity of rice consumed may be observed. This would not affect long-term growth, but, it would have an effect on this year’s growth, as it would record an unexpected reduction.

Given that this is now the longest shutdown in history, there is potential for all of the above to materialise. While the possibility that the shutdown will last for the whole quarter is limited, the most likely scenario is that it will affect growth in the first quarter of 2019, especially if no deal is reached by the end of the month when wages are due. With an estimated 800,000 federal workers not receiving any pay, and an additional 4 million contractors who, in addition to being furloughed will receive no back pay, the total number of unpaid workers climbs up to 3.2% of total payrolls. Even if these people only cut consumption by 10%, then a 0.22% decline in annual GDP can be expected. This would amount to a 0.8% decline in the first quarter GDP, which amounts to 0.05% per week. The official White House estimate stands at 0.13% per week, which more or less assumes a 25% reduction in spending – a more realistic response.

Overall, the long duration of the shutdown is expected to hurt the economy while the effect should be much larger if it continues after the end of the month. Ironically, we will not be able to observe the extent of the reduction given that the government departments in charge of the publishing the data are affected by the shutdown! Thus, the PMIs next week will be the ones investors should be more interested in to gauge the US economy’s behaviour over this month.