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Prolonged Government Shutdown Could Wither Confidence And Even Trigger Recession

Government Shutdown Economy

First Posted: 03/30/11 11:07 AM ET Updated: 05/29/11 06:12 AM ET

An extended federal government shutdown could devastate the U.S. economy by dealing a blow to Americans' confidence, experts said Tuesday.

If lawmakers cannot reach agreement on a bill to fund the government by April 8, a broad array of federal programs will come to a halt. Although most shutdown plans remain classified, during the last major federal government shutdown in 1995, certain health services were shut down. Court cases were delayed. And federal workers were furloughed. This time around, some fear low-income families will miss crucial government payments. But there is another consequence that could make all of those challenges far worse: The economy could slip back into recession.

Already, Americans face a host of economic woes. The unemployment rate remains high. Home prices are still falling, aggravating a widespread foreclosure crisis. Oil prices are rising, pushing transportation costs steadily higher and tearing precious resources from the economy.

In this context, a prolonged federal shutdown would drain Americans' confidence in their government, hobbling spending, borrowing and investment -- and pushing the economy toward recession, said Mark Zandi, chief economist of Moody's Analytics.

"Confidence is already very, very fragile," said Zandi, who has been an economic adviser to both Republican and Democratic lawmakers. "A very short shutdown would be manageable, but the damage that it would do to the confidence in the economy would quickly mount with each passing day."

After about two weeks, that loss of confidence would "be fodder for a new recession," Zandi wrote in a report last month. On Tuesday, he said that report remains as applicable as ever.

Republican lawmakers have warned that, if the government does not rein in federal spending, it could incite a crisis of confidence among investors in U.S. debt, which could make financing U.S. debt much more expensive. But economists say public confidence could fast wither if Congress fails to pass a budget for the remainder of the fiscal year, wounding the economy from the inside.

Economic strains at home, the conflict in Libya, and the continuing crisis in Japan have already made Americans worried. Both major indices of consumer psychology plummeted this month: On Friday, Reuters and University of Michigan said their consumer sentiment index fell in late March to its lowest level since November 2009, down from February's three-year high. On Monday, the Conference Board said its index of consumer confidence fell sharply in March, reversing two months of strong gains.

Confidence has far-reaching economic implications. It affects consumer spending, which drives about two-thirds of U.S. economic activity. Confidence also influences whether an entrepreneur will take out a loan to expand a business, or whether an investor will provide a fledgling company with capital. In the stock market, where trillions of dollars are at stake, investors' decisions are often influenced by a feeling of confidence.

"Even though the actual direct effects of a two-week government shutdown may not seem like such a big deal, it could trigger a mass panic or sell-off, or other types of market dynamics that could be really hard to predict or control," said Andrew Lo, professor of finance at the MIT Sloan School of Management.

He added that Americans might "start wondering whether or not government works at all."

On a short-term basis, the strain from a government shutdown would occur on a micro level, as struggling families would go without payments, and workers would be forced to stay home. But these issues would most likely have little broader impact on the economy during the first few days of a shutdown, said Alec Phillips, an economist at Goldman Sachs.

And not all aspects of government would be affected. Functions deemed "essential," such as national security, would continue.

Some economists are skeptical that a shutdown would affect the broader economy.

"In many respects it's the bureaucracy that shuts down -- the statistical agencies that collect and report on the state of the economy and commerce, various kinds of permitting and approvals," said Brian Bethune, chief financial economist for North America at IHS Global Insight. "These shutdowns have happened before, and they really haven't had that big of an impact on the economy."

During the last major government shutdown, under President Bill Clinton, confidence dipped. The freeze began in December 1995 and lasted through January. During that period, consumer confidence dropped 10.8 points, which at the time was its biggest monthly fall in nearly four years, according to the Conference Board's records.

The economic consequences, at that point, were minimal. The Standard and Poor's 500 stock index, after falling in January 1996, soon rebounded.

But this time around, a shutdown would occur during a period of historic weakness.

"It could be a nonevent, in which case everybody takes a two-week vacation, and they're back to normal afterward," Lo said. "Or it could turn into something much more ugly."

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