The latest reports on real growth and personal incomes issued last week by the Bureau of Economic Analysis include equally cautionary news for the economy and President Biden’s prospects in 2024. Employment, incomes, and consumer spending all remain strong despite sharply higher interest rates. But the economy is balanced on a knife’s edge because businesses have been cutting back on investment and production.
The result is that growth slowed sharply in the first quarter of this year, leaving an expansion that’s very sensitive to adverse shocks. With these conditions, the House Republicans’ strategy to threaten a debt default, unless Democrats agree to cut spending deeply, could endanger Biden’s reelection because an unprecedented default or even budget austerity could tip the economy into recession.
The new GDP report tells the story: Adjusted for inflation, GDP growth has slowed from 3.2 percent in the third quarter of 2022 to 2.4 percent in the fourth quarter and now 1.1 percent in the first quarter of this year. But the report also shows that most Americans are still unfazed: Consumer spending jumped 6.5 percent over the last quarter, the largest gain since Spring 2021. And last week’s BEA report on personal incomes tells us why. With employment still surging—up by more than 1 million jobs from last December to February—and wages holding their own, total disposable incomes grew at an 8 percent annual rate after inflation. These are the largest gains in two years.
The slowdown in growth is just what the Federal Reserve wanted when it raised interest rates 10 times from March 2022 to April 2023. Inflation has decelerated somewhat as interest-sensitive spending has pulled back. Business fixed investment declined 3.2 percent over the past year, and housing investments fell 10 percent. But most of that happened in the last two quarters of 2022. In the first quarter of this year, business investment actually edged up a bit (0.7 percent), and residential investment was nearly flat (down less than 0.2 percent).
The culprit behind the sharp slowdown in the first quarter was inventory investments, which also respond to interest rates. In fact, the BEA estimates that the steep drawdown in business inventories subtracted nearly 2.3 percentage points from GDP growth. So, if inventories had not declined, GDP would have grown almost 3.4 percent, consistent with the substantial gains in incomes and consumer spending.
It matters because inventories fall when sales outpace production. So, while Americans keep buying as total income keeps rising, businesses that don’t believe it will last have slowed production.
This means that the economic outlook for the rest of this year and into 2024 depends, in large part, on business expectations improving. If they improve, production will increase, employment and incomes should continue to grow, and the economy should be fine.
But if businesses remain pessimistic, production will likely continue to fall, companies will lay off more people, total incomes could decline, and consumer spending could stall—and the economy could slip into recession by early 2024 or sooner. That could happen if the Fed continues to aggressively raise interest rates, confirming business anxieties that already are affecting production.
It also could happen even if the Fed stays its hand because of the standoff between House Republicans and the White House over the debt limit and next year’s budget. Whether Kevin McCarthy realized it or (more likely) stumbled into it under White House pressure to produce his own budget plan, the GOP threat to scuttle the debt limit unless Democrats accept big spending cuts has set up a dangerous scenario for the president.
If neither side blinks and the Treasury defaults in June, financial markets will swoon, and the shock to a vulnerable economy could quickly bring on a recession. Biden will rightfully blame the kamikaze MAGA Republicans for the carnage, and broad public outcry almost certainly will force enough House Republicans to capitulate in short order. But presidents always bear political responsibility for the economy. Biden could be an easy target for Donald Trump and other Republican presidential hopefuls for not averting the crisis and subsequent downturn.
It’s also possible, even likely, that GOP donors, governors, and public opinion will force House Republicans to blink and accept a clean debt limit. And since Biden has promised to try to cut a budget deal with McCarthy once a clean debt limit is approved, its passage will likely be tied to a side agreement to cut spending in the fall appropriations.
That’s also a treacherous course for the president. A similar scenario in 2011 forced Barack Obama to accept a major dose of austerity that kept growth low for years. This time, with growth already slowing, substantial cuts could tip the economy into recession as the president campaigns for reelection—and he won’t be able to shift the blame to anyone else.
There is another way out for Democrats—call it a third way since it will require the strategic skills of a Bill Clinton. The economy can likely absorb modest spending cuts without tipping over, assuming no debt default. But Biden will need some House Republicans to accept such a partial deal. Like Clinton, Biden will have to plan for a stalemate that shuts down the government by galvanizing public opinion against McCarthy and the radical Republicans, so they shoulder so much blame that they’re forced to agree.
Clinton pulled it off in late 1995, but he went into the fight with a more robust economy and approval ratings north of 50 percent. It will be a bigger challenge for a president with more modest growth and less public support. The good news for President Biden is that the House Republicans’ positions on accepting debt default and slashing federal spending are extremely unpopular. The bad news is that if he cannot pull off such daunting political jujitsu, a vulnerable economy sinking under the weight of a debt default or heavy austerity will give even Trump a real shot at beating him next year.