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Why defense spending plunged 22% last quarter — and killed GDP

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On Wednesday, the government announced that the economy had shrunk at a 0.1 percent annual pace between October and December. That came as a surprise to most economists, who were expecting at least modest growth. So what happened?

Less spending from the Pentagon, for one. Government defense expenditures dropped by a staggering 22.2 percent annual pace between October and December. According to the Bureau of Economic Analysis, the Pentagon spent significantly less on just about everything except military pay. Had the Pentagon not cut back on spending, the economy would have grown at a weak but positive 1.27 percent pace.

Was this big plunge in defense spending unusual? Yes and no. To a certain extent, it's part of a pattern: Defense spending often rises in the third quarter of a year and drops in the fourth quarter. Here’s a graph of the quarterly change in defense spending since 2010. Note the usual highs in September and lows in December of each year:

There's a reason for this. The fiscal year ends in September, and government agencies typically try to spend all the money Congress allotted them for that year by then — otherwise, they fear, they'll get a smaller budget next time around.

“In the Pentagon, you have to use it or lose it by the end of the fiscal year in September,” said Lawrence Korb, a former assistant secretary of defense now at the Center for American Progress, in a recent interview. “You see this a lot. ‘We’ve got to fly a lot this month for training, otherwise Congress will take back the money they gave us.’"

Yet the ups and downs were especially sharp in 2012 — soaring 13 percent in the third quarter and dropping 22.2 percent in the fourth quarter. Part of that is due to the fact that defense spending is shrinking overall, thanks to budget pressures and the drawdowns in Iraq and Afghanistan.

Another possibility, as Michael O'Hanlon of Brookings told me, is that the Pentagon has been preparing for the sequester budget cuts that had originally been scheduled for January. (They've since been pushed back until March.) The Defense Department was facing the prospect of losing money that had already been budgeted over multiple years but hadn't been spent. That led to a big spending spree in the third quarter, which was followed, inevitably, by a drought in outlays in the October through December.

In any case, this episode does show that a sharp contraction in government spending can have a powerful effect on GDP. The slightly encouraging news, however, is that many analysts expect this to be a one-time blip. Paul Ashworth, an analyst with Capital Economics called this GDP report "The best-looking contraction in US GDP you'll ever see" in an e-mail release. That's in part because he doesn't expect military spending to be quite so erratic again in the months ahead.

Related: Why defense spending surged 13% in the third quarter of 2012 — and boosted GDP