Economy's Biggest Drag Right Now Is Government

Government has become its own worst enemy when it comes to the economy, with public spending putting a damper on growth that otherwise continues at a steady if unspectacular pace.

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Friday's gross domestic productreport confirmed what a drag government can be: While consumer spending grew at a 2.9 percent clip, state and local governments cut back spending by 1.2 percent on an annualized basis and the federal government pulled back by 5.6 percent.

As a result, the GDP number showed just a 2.2 percent improvement. The report disappointed economists, some of whom had the number as high as 3 percent and beyond, and cast an uncertain future on a stock market dependent on Federal Reserve stimulus for growth.

"None of this is all that surprising, so where is the miss?" wondered Brown Brothers Harriman global currency strategist Marc Chandler, after noting some fairly pedestrian and in-line quarterly growth results. "Contrary to what passes as conventional wisdom, the main drag is coming from the government itself."

Before anyone starts thinking that Washington suddenly has gotten religion on spending, the bulk of the federal government cuts came from defense spending, which plunged 8.1 percent.

State and local governments, facing the necessity to balance their budgets against declining revenue (not to mention the specter of Meredith Whitney'smuni bond default forecast) likely will continue to cut, though that's not as certain with their federal counterpart. Washington's drop in spending came after a 19.1 percent decrease in the fourth quarter of 2011.

"The government spending plunge is unlikely to repeat for a third quarter (in 2012 at least) and an inventory drag in 2Q only masks moderate demand gains," Citigroup economist Steven C. Wieting said. "But the 1Q GDP data should limit remaining optimism that U.S. economic growth will accelerate significantly this year."

So what does this all mean?

Investors are watching the Federal Reserve closely for signs that the U.S. central bank might step in and provide more stimulus once Operation Twist ends in June.

The Fed currently is buying long-dated bonds and selling shorter-dated notes in an effort to stimulate risk and drive down lending costs. At the same time, it is rolling over the $2.8 trillion already on its balance sheet in the form of Treasurys as well as mortgage and other debt.

Some are hoping that Chairman Ben Bernanke and Co. will be willing to step in with a third round of balance sheet expansion — quantitative easing — to keep goosing the market through the economic trudge. But the GDP progress, halting as it is, likely will forestall if not completely derail QE3 prospects.

It's all part of "Bad Goldilocks" phenomenon, in which the economy doesn't grow quickly enough to inspire confidence but moves just enough to keep the Fed at bay. Central bank critics worry that all the liquidity efforts will spur inflation, not to mention uncertainty over what happens once the Fed has to start unwinding all that debt it is holding.

Also remember: Out there not so far in the future is the "fiscal cliff" of which Bernanke has warned will appear if Congress cannot agree on deficit reduction and thus face an automatic round of steep spending cuts and tax increases at the end of 2012.

"Enthusiasm for equities is likely to be curbed by a turn in the US profit cycle, an absence of additional unconventional monetary stimulus from the Fed and a renewed flare-up of the crisis in the euro-zone," John Higgins, senior market economist at Capital Economics, said in a note.

"The latter should weigh particularly heavily on stock markets in the region, even though valuations are now low from a historical perspective and relative to the US," he added.

Indeed, there's a lot not to like about an economy that relies on government spending as its primary growth engine. Just ask anyone in Europe.

Ostensibly, the U.S. economy is consumer-driven, with private spending amounting to 70 percent of GDP. But several economists doubted that the robust 2.9 percent spending increase in the first quarter could last, raising further questions about where we go from here.

"We assumed that growth would be driven primarily by final demand, but, inventories contributed 0.6 (percentage points) to GDP, putting real final sales at a weak 1.6 percent annualized growth rate," said Neil Dutta, U.S. economist at Bank of America Merrill Lynch. "Moreover, the strength in consumer spending and contribution from motor vehicle output look unlikely to repeat in future quarters."

Government policymakers, then, face a dicey dilemma: Continue spending and risk falling further into the fiscal abyss, or cut back and deal with a prolonged future of uninspiring GDP numbers.

"The dagger (from the GDP letdown) came from a second straight steep drop in federal government spending due to plunging defense outlays," observed Pierpont economist Stephen Stanley. "Boy, wait until these budget cuts start to kick in."

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