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Implications of a U.S. Government Shutdown

Published: 4/8/2011
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The macroeconomic consequences of a federal government shutdown would be limited, as long as it is brief. Far more severe consequences would result if there is a similar deadlock over the looming requirement to raise the federal debt limit.

Fiscal year 2011 is now more than six months old, and there is still no federal budget in place. At the time of writing, the impasse over the budget continues, and without an agreement it seems highly unlikely that yet another temporary "continuing resolution" to fund the government will be passed. It is not clear whether the budget itself is the stumbling block, or other policy riders attached to the budget, but regardless of the reason, if no agreement is reached, the federal government will "shut down" effective midnight today, Friday, April 8, because it will have no authority to spend.

The "shutdown" sounds much worse than the reality, though, because most of the federal government will actually continue to function.

What a Federal Government Shutdown Really Entails

The shutdown will mean the furlough of non-emergency personnel (who would not be paid and who would be forbidden to work) and shutdown of agency activities and services. But there are many exceptions. Personnel and activities involving the "safety of human life or the protection of property" are exempted. These personnel would work—but they would not be paid as long as the shutdown remained in place. Additionally, some operations would be unaffected because they depend on permanent or longer-term appropriations, or have their own source of funding. Other notable exceptions include the president, members of Congress, and presidential appointees.

The most recent White House estimates anticipate that roughly 800,000 federal employees would be furloughed as a consequence of a federal government shutdown. This represents roughly 36% of the total 2.2-million federal civilian employees (excluding U.S. Postal Service workers).

Among the affected activities, the Internal Revenue Service would stop processing refunds for paper-filed returns; the Small Business Administration would not process applications for business loans; the Federal Housing Administration would not be making new loan guarantees; the State Department would not process visas and passport applications; national parks and museums would shut down.

Additionally, the flow of economic data would slow to a trickle. Most economic data releases come from the Commerce Department or the Labor Department, and they would cease. Additionally, new data would not be collected, delaying releases when the government comes back. Data coming from the Federal Reserve (notably, industrial production) would not be affected.

Among the key agencies and programs that would not affected by a shutdown: the Federal Reserve, the U.S. Postal Service, all activities pertaining to law enforcement, border security, and military operations that involve the safety of human life and the protection of property; the Social Security Administration would continue paying existing benefits, although uncertainty remains over the processing of new applications; Medicare would continue to pay benefits.

Federal Contractors: Time Is Money

In addition to federal employees, the federal government employs contractors who would suffer losses from a government shutdown. First, a shutdown would mean that no new contracts could be signed, thereby putting some activity on hold. Second, contractors working on existing contracts on government premises, or requiring the assistance of federal employees would not be able work. In cases where contracts depend on longer-term appropriations, contractors would keep working (if their activity is independent of federal employees and federal premises), in the knowledge that payment would be made but might be delayed.

The Macroeconomic Impact

Estimating the total macroeconomic impact of a government shutdown is very difficult given the uncertainty surrounding the impact on federal and federally contracted activities and programs, and over how long any shutdown would last. A brief shutdown of a few days would have a trivial impact—but costs would mount the longer the shutdown lasted.

We can say something about the impact of the federal employee furloughs. In the national income accounts, federal employee compensation is a component of GDP (since the value of their services is measured by their compensation). Those employees who keep working would get paid once the shutdown ends. Furloughed employees would probably get paid, too, after the event—but their absence from work would directly lower GDP.

With 800,000 employees furloughed, and assuming average compensation of $110,000 per year, the total GDP-basis spending impact represents $1.7 billion per week. The average compensation figure may sound large, but remember that it includes all benefits as well as base salary.

A loss of $1.7 billion in GDP for one week would reduce the second quarter's growth rate by about 0.18 percentage point. Each additional week would take off another 0.18 percentage point.

The negative GDP impact would probably work through a higher price deflator for government compensation, rather than through lower nominal spending. In previous shutdowns, furloughed employees have been paid retroactively for the period that they were off work. That means that nominal government spending on employee compensation is not affected, but that real spending is reduced, because employees are being compensated for days on which they performed no services. The price index for employee compensation jumps higher.

Beyond the direct impact on employee compensation, the picture gets much murkier. For some guidance we can look back to the last federal government shutdown in 1995–96. Similarly to today, that shutdown resulted from a budget impasse involving a Democratic president (Clinton) and a Republican-controlled Congress (in 1995, the Republicans controlled the Senate as well as the House; the key Republican protagonist was House Speaker Gingrich).

There were actually two shutdowns, from November 14 to November 19 and from December 16 to January 6. The first five-day shutdown was more wide-ranging than the second 21-day shutdown, because by December 16 funding bills had been passed for some parts of the government.

In the fourth quarter, when the shutdown was concentrated, real federal government purchases fell at an annual rate of 14.2%, but then bounced back by 8.6% in the first quarter. The fourth quarter's 14.2% decline knocked 1.0 percentage point off that quarter's GDP growth rate. But that decline was not necessarily all due to the shutdown (the CBO has estimated that the shutdown itself was responsible for a loss of 0.5 percentage point).

What is not in doubt is that the impact of a shutdown would magnify the longer that it is extended. Federal government employees (whether working or not) would not receive paychecks. The impact on each employee would depend on how much financial cushion they have to tide them over. But their ability to maintain their levels of spending or to service their debts would be damaged.

Taxpayers who have filed paper returns would not receive their tax refunds (apparently this does not work in reverse—if you send in a check for taxes due, it will be cashed). The housing market, already deeply distressed, would be hurt by the shutdown in FHA mortgage guarantees.

It is also fair to assume that the reaction of financial markets—notably the stock market and the dollar—would become increasingly negative the longer the dispute drags on, as it would show the U.S. federal government unable to fulfill its most basic functions, setting its own budget and delivering its services. It would also increase the fear that a potentially much more damaging confrontation could follow—over raising the federal debt limit.

More Worries on the Horizon

Unique among advanced nations (possibly among any nations), the U.S. government imposes a federal debt limit that, when reached, must be extended by law to allow the government to borrow more. Treasury Secretary Timothy Geithner recently warned Congress that the current debt ceiling of $14.29 trillion would be breached by May 16, based on current receipt and expenditure projections. He added that this deadline could be pushed back until July 8 with "extraordinary measures" (mostly accounting maneuvers).

The argument against having a debt limit is that when Congress makes revenue and spending decisions, and decides to run deficits, those decisions automatically imply that the federal debt will rise. Having a debt limit also means that Congress cannot implement the revenue and spending decisions that it has already taken. But regardless of whether having a debt limit is a good policy, the fact remains that it exists.

It is possible that the Republican-controlled House will refuse to extend the debt limit without an agreement on more severe spending cuts. If this creates another impasse with the Democrats, the federal government would hit the debt limit. The consequences would be far more severe than those of a partial government shutdown. In effect, the government would have to decide which bills to pay using only revenues coming in—which of course fall far short of current spending.

The exact consequences are unknown—since we have not seen this scenario before—but Social Security payments, Medicare payments, national security commitments, and interest and principal payments on the national debt would all be at risk. Failing to service or redeem debt would lead to damage cascading though financial markets, as debt-holders would be unable to meet their own obligations. It is hard to think of a bigger self-inflicted wound for a $10-trillion debtor than failing to service that debt. The reputational consequences would be long-lasting (meaning higher interest costs). The consequences of a partial federal government shutdown for a few days in April would be a pinprick compared to the consequences of failing to raise the debt ceiling.

by Gregory Daco and Nigel Gault

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