Deal Puts U.S. on Austerity Path as Economy Falters

Tuesday, 02 Aug 2011 06:32 AM

 

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The federal government looks to be getting out of the business of trying to spur the economy just as the U.S. expansion shows increasing signs of faltering.

A deal struck over the weekend to cut $2.4 trillion or more off budget deficits over a decade marks the beginning of a prolonged effort to put the government’s finances into better shape. While the immediate economic impact from the agreement is likely to be small, it will add to a reduction in growth next year of 1.5 percentage points coming from the expiration of past stimulus programs, according to economists at JPMorgan Chase & Co. and Deutsche Bank Securities.

“Over the next 10 years, there will be further spending cuts and higher taxes, and that’s not good for economic growth,” said Paul Dales, senior economist for Capital Economics Ltd. in Toronto. “It is the start of a meaningful move toward fiscal consolidation.”

The shift from stimulus to austerity coincides with a slowdown in the two-year recovery. A report last week showed that gross domestic product grew at an annual rate of 1.3 percent in the second quarter of the year following 0.4 percent in the first three months, prompting economists to warn of possible relapse into recession.

The economy will suffer another blow next year with the expiration of a temporary 2 percent payroll tax cut, an end to extended unemployment benefits and completion of the $830 billion stimulus program that President Barack Obama signed into law more than two years ago. Obama will press Congress to extend a cut in payroll taxes before the end of the year, White House press secretary Jay Carney said yesterday.

‘Fiscal Drag’

“There is a risk to the recovery that a large amount of fiscal drag is coming at a time when the economy is struggling,” said Peter Hooper, chief economist for Deutsche Bank Securities in New York.

Congressional leaders agreed last weekend on a deal that would cut the federal deficit while raising the nation’s debt ceiling by $2.1 trillion. The pact, which was approved by the House last night and is set to be considered in the Senate today, contains $917 billion in cuts, with the balance to come later this year from a special committee of lawmakers.

The debt deal would reduce government outlays by $21 billion in the fiscal year that begins Oct. 1 and by $42 billion in the following year, according to an analysis by the Congressional Budget Office. That pales in comparison with the $15 trillion U.S. economy.

‘Small’ Impact

The impact of the agreement on the economy next year “is going to be small, maybe a few tenths of a percentage point,” as most of the cuts are put off to the future, said Michael Feroli, chief U.S. economist for JPMorgan in New York.

The turnabout in the long-term budgetary stance also puts pressure on Federal Reserve Chairman Ben S. Bernanke and his central bank colleagues to keep monetary policy easier for longer to offset the economic effects from the tighter fiscal outlook.

“The more fiscal drag there is, the less of a case there is for monetary tightening,” said James O’Sullivan, chief economist for MF Global in New York. He predicts the Fed will keep interest rates at record low near zero and its balance sheet near a record high of $2.87 trillion through this year and into 2012.

Job-creation efforts already have been hampered by cutbacks in the public sector. Since May 2010, total government employment has dropped by 916,000 jobs, according to Labor Department data.

Stocks Fall

U.S. stock prices bounded ahead in early trading yesterday on news of the budget deal, only to fall back later on fresh signs of economic weakness. The Standard & Poor’s 500 Index ended 0.4 percent lower at 1,286.94 for a sixth straight daily loss. European stocks fell to the lowest level in almost 10 months today amid concern that a U.S. slowdown is derailing global growth.

The 10-year Treasury yield fell four basis points to 2.71 percent as of 10:05 a.m. in London, after touching 2.69 percent, the least since November.

The Institute for Supply Management reported yesterday that its factory index slumped to 50.9 in July, the lowest level in two years, from 55.3 a month earlier. A reading below 50 in the Tempe, Arizona-based group’s index signals the manufacturing industry is contracting.

Uncertainty Resolved

Federal Reserve Bank of St. Louis President James Bullard voiced hopes last week that a resolution of the debt-ceiling impasse may remove an unknown that has restrained growth.

“Once this last uncertainty is resolved, the path to faster growth may be open,” Bullard said in a speech in Jackson Hole, Wyoming.

Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., was more downbeat.

“The consequences of the debt ceiling debacle are going to be long-lasting,” said El-Erian, whose Newport Beach, California-based firm manages the world’s biggest bond fund. “It inflicted a hit to both national and international confidence.”

History suggests that fiscal consolidation can have pluses and minuses for an economy, said Michael Mussa, a former chief economist at the International Monetary Fund and now a senior fellow at the Peterson Institute for International Economics in Washington.

Deficit to Surplus

The U.S. economy grew at an average 4 percent per year from 1994 to 2000 as the federal government’s budget moved from deficit to surplus under former President Bill Clinton.

Japan was not so fortunate, Mussa said. Its economy fell back into recession in 1998 after it raised consumption taxes and took other steps to tighten fiscal policy.

In choosing austerity, the U.S. is embarking on a course that some European nations already have pursued with mixed results. A new coalition government in the United Kingdom last year enacted a program of reduced spending and tax increases aimed at closing the budget deficit.

Creditors have welcomed the austerity measures. The yield on the U.K.’s 10-year bond has fallen to 2.8 percent from 3.85 percent on May 12, 2010, when the coalition government was formed, today.

George Magnus, senior economic adviser to UBS Investment Bank in London, said the fiscal retrenchment has established the government’s credibility.

Economic growth has been less impressive. In the second quarter, the U.K. economy grew 0.2 percent from the previous quarter. That left total output barely above the level reached in the third quarter last year.

“The economy is at stall speed even before the public expenditure reduction starts to kick in,” Magnus said. “The omens for this in the U.S. are really poor. The situation is quite comparable.”


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