Pretty much all forecasters expect improvement in 2014 largely from what they call a reduction in fiscal drag. Their logic goes something like this (with the actual numbers varying a bit with different analysts):

Without the deficit reduction in 2013 that subtracted 2% from growth, growth would have been 4%. Therefore, when the fiscal drag ends, growth will return to the underlying 4% pace.

I’m suggest their logic is faulty.

The difference is that of ‘adding less’ vs ‘subtracting’

It’s not like the private sector alone was expanding at a 4% clip, and then govt came along and took away 2%.

It’s that by my count the private sector was growing at -2%, and govt was going to add 6% to that for 2013, but proactively reduced its support to only 4% in 2013 by cutting spending and raising taxes, resulting in 2% GDP growth rather than 4%. And for 2014 that ‘lost support’ will not be added back.

Expanding:

Assume, for example, GDP started 2013 at 100, and was forecast to go to 104 as stated above. Assuming nominal growth about 1.5% over real growth, let me push that up to 105.5.

That assumption included, say, federal deficit spending of 6% of GDP (starting at maybe a 7% rate and ending at maybe a 5% rate).

That is govt was forecast to make a net positive 6% contribution to spending by spending that much more than its income, aka ‘credit expansion’. Or, said another way, the total government spending contribution was over 20% of GDP, with all but 6% of that ‘offset’ by taxation that reduced incomes elsewhere.

Also note that the economy is currently ‘demand constrained’ as there is an output gap. In other words GDP could be higher, as a matter of accounting, simply by, for example,
govt hiring more people who are currently not working for pay, via the govt spending that much more than its income (adding to the deficit). Or GDP could be lower simply by govt cutting back, which is what actually happened, as recognized by the analysts.

That is, net govt spending was proactively reduced by about 2% due to tax increases and sequesters.

And federal deficit spending averaged perhaps 4% of GDP rather than 6% of GDP, thereby reducing said GDP..

That is, government contributed that much less to GDP. And that lost contribution will not be restored, as, if anything, there will be further deficit reduction forthcoming from Congress in 2014.

So my point is the 4% forecast for 2013 was not that much private sector growth that was then reduced by the deficit reduction measures. Instead, the growth forecast included the federal deficit contributing 6% to GDP, which was subsequently reduced by Congress to only 4%.

In fact, without the remaining 4% contribution of that net federal spending, nominal GDP might have been -.5% and real -2%.

And 2014 is starting out with federal deficit spending forecast to add only about $600 billion, which is less than 4% of GDP.

So to recap, the original forecast for 4% growth included the full 6% contribution from govt. And when that contribution was proactively reduced to 4%, growth forecasts were correctly cut to 2%.

And my point is that the assumed ‘underlying growth rate’ of 4% in fact presumed the then 6% contribution from govt which was subsequently reduced, thereby lowering ‘the underlying growth rate’ for 2013 to 2%.

It’s not that the private sector was responsible for 4% growth and that the govt took away 2% of that with the tax increases and sequesters.

In fact, it was more that the private sector was -2% on its own due to ‘demand leakages’/unspent incomes/savings desires including non residents) and govt support that was to boost that to +4% was cut back, resulting in a 2% rate of GDP growth for 2013.

I am not saying that GDP growth can’t pick up in 2014.

I am saying that the logic behind the widespread forecasts for a pick up in growth is universally faulty.

And that if growth does pick up it will be from an increase in non govt ‘spending more than incomes’, aka an increase non govt credit expansion.

While this is certainly possible, traditionally it comes from housing, which currently isn’t generating any credit expansion, and cars which are no longer generating meaningful increases.

Worse, in prior cycles we got the private sector credit expansion need to support relatively low output gaps only from expansion we never would have let happen if we had been aware of the consequences. These included the Bush sub prime expansion, the Clinton .com/y2k credit expansion, the Reagan S and L credit expansion, and the earlier Wriston emerging markets credit expansion. And I don’t see anything like that happening currently.

And so without the prerequisite acceleration of non govt credit expansion, the maths tell me 2014 GDP growth will remain at best at approximately the 2% level of 2013. And, with so little support from federal deficit spending, I see serious downside risks should private sector credit expansion falter for any reason.

And note too that the continuation of 2% GDP growth closes the output gap only by reducing estimates of potential output, primarily by assuming the drop in the participation rate is structural.

And even the modest employment gains we’ve seen are at risk. The growth rate of employment has been almost identical to the underlying rate of real growth, which improbably implies no productivity growth. So if there is any positive underlying productivity growth, and real growth remains the same, employment growth will decline accordingly.

Lastly, the ‘automatic fiscal stabilizers’ are continuously at work. So when private sector credit expansion does contribute to growth, the govt ‘automatically’ cuts back its support via reduced transfer payments and increased tax receipts, thereby tempering the positive effect of the private credit expansion, and making it that much more difficult for the growth to continue.

This means that even the current 2% growth rate will at some point get ground down by our current institutional structure. With growing risks that this could be very much sooner rather than later.