Government shutdown: How much will it harm the economy?

A government shutdown won't have much of an economic impact if it lasts just a few days, but a prolonged shutdown could become a drag on overall consumer and business confidence. 

The US government shutdown that began Tuesday is a nuisance to many Americans and a hardship for legions of federal employees, but its impact on the economy is expected to be only modest – at least at first.

That’s the widely held view of forecasters. Economic damage could rise, however, if this partial halt of federal activity starts running longer than a week or two.

“Most of the federal government will keep running in the event of a shutdown, but a significant number of federal employees will be furloughed without pay, perhaps as many as one million,” write economists Ethan Harris and Michael Hanson of Bank of America Merrill Lynch. “The impact on … GDP growth should rise with the length of the shutdown.”

In their estimate, the first couple of days of shutdown has little discernible impact on gross domestic product (GDP) for the fourth quarter. But a two-week shutdown could lop half a percentage point off the annualized pace of economic growth for the quarter.

For reference, economists in a recent survey predict that GDP will grow at a 2.6 percent rate in the fourth quarter.

If the shutdown goes on for a full month, the Merrill Lynch economists see a harsher toll, crimping that growth rate by 2 full percentage points.

Many economists are more optimistic. The investment firm Morgan Stanley pegs the likely drag on growth at 0.15 percentage points for each week of a shutdown.

“For every day of shutdown, federal compensation … is reduced by $400 million,” said economist Alec Phillips of Goldman Sachs, in an analysis Wednesday. “The effect is linear; a five-day shutdown would have five times the effect of a one-day shutdown.”

Economists acknowledge, however, that predicting how the shutdown will affect the economy involves crude estimates.

An important wild card, for example, is whether the sight of disarray in Washington will affect wider consumer confidence – resulting in declines in spending or stock prices.

Efforts to estimate the shutdown’s impact stem in part from past experience. This isn’t the first time America has seen a partial shutdown as Republicans and Democrats tussle over legislation to fund the government.

During a US government shutdown back in 1995-'96, effects on the US economy were modest and there was minimal global impact.

But a few caveats to a “not to worry” conclusion are worth noting:

• Effects on consumer confidence could grow if the shutdown persists. Economists generally agree with a line President Obama gave in a public appearance this week: “The longer this shutdown continues, the worse the effects will be.”

• This isn’t 1996. Back then, the economy was well clear of recession, entering an era that would prompt the Federal Reserve chairman to voice a question about “irrational exuberance” in the stock market. Today, the economy is growing but in a much more fragile way, both within the US and in other nations. And unemployment remains high, at 7.3 percent in the US and 12 percent in the euro zone.

• The shutdown isn’t happening in isolation. By about Oct. 17, the US Treasury is set to run out of borrowing room. That prompts the need for Congress to act to raise the statutory cap on US debt, which currently stands at $16.7 trillion. That promises to become another case where fiscal legislation could bog down in partisan rifts over things like federal spending, tax reform, and Obamacare.

The effects of a debt-limit impasse could be severe for the US and the world, raising fears of a possible default by the US Treasury.

Just the act of watching politicians dance near the brink was enough to cause a sizable fall in US consumer confidence and a downgrade of the US credit rating in 2011, the last time a debt-limit showdown occurred.

And stock markets around the world fell in tandem back then – a time when fiscal challenges were also weighing on European economies.

In the past week or so, US stock prices have traded generally downward, but not in a dramatic way.

The shutdown stems from a failure by Congress to agree on legislation to fund the government for a new fiscal year. Republicans are seeking to use the moment to gain leverage on everything from federal spending levels to – most prominently – their goal of thwarting the health-care reform law that President Obama signed in 2010.

It’s not really all of government that is closed. Operations deemed essential (such as national defense and air traffic control) continue, and so do programs that have funding that’s independent of Congress’s annual appropriations process. Social Security is a prime example.

But the effects are considerable still, because the federal government is America’s largest employer.

Some of the quickest effects are being felt in the Washington, D.C., area. Thousands of federal workers are staying home without pay, not frequenting local restaurants. The closure of museums and National Park sites ripples out to affect vendors of T-shirts and hot dogs. The shutdown could also put a damper for a time on what has been one of the nation’s hottest real estate markets.

But the shutdown’s effects go far beyond Washington.

Federal employees are in all 50 states, and a key channel of the shutdown’s impact is through the furlough of as many as 800,000 federal workers.

Federal employee compensation is considered GDP produced by the federal government, according to the forecasting firm IHS Global Insight in Lexington, Mass. The furlough of 774,000 workers – a number that assumes the same 36 percent share of the federal work force that was furloughed in 1995 – would result in a hit to GDP of 0.16 percentage points per week, the firm estimates.

Conversely, once a shutdown ends, much of the lost pay is expected to be restored. Such a down-and-up cycle in federal payrolls could all occur within the fourth quarter – helping to mute the shutdown’s impact on GDP.

But again, a long shutdown could become a drag on the overall confidence of US consumers and businesses – much like what occurred in that debt-limit debate of 2011.

“Consumer confidence, which has been trending down recently, would also be likely to suffer as consumers feel increasingly concerned about the government’s ability to avoid a self-inflicted wound,” writes Gregory Daco of Oxford Economics in New York.

Bottom line: The shutdown is a moment created by politicians, but it has at least some real economic consequences. If the consequences start looking more than modest, those politicians could quickly feel pressure to find a path out of their shutdown.