Debt Deal: ”It’s like Curing a Drunk with Vodka”

By David Lawder
Reuters
August 1, 2011

The tentative deal to avoid a crushing debt default is at best a mild relief for the U.S. economy that nearly stalled in the first half of the year and has yet to show signs of any realistic pickup.

The plan for $2.4 trillion in spending cuts over a decade, if backed by lawmakers, would help lift some of the uncertainty that has weighed on investors, businesses and consumers unsettled by talk about a possible new and deep U.S. financial meltdown.

Still, it does not decisively remove the threat that the nation’s AAA credit rating could be downgraded, an action that would raise borrowing costs across the board, and the prospect of further cuts ahead will cut short any celebrating.

“This will have minimal impact on the economy. The cuts are not there for the first couple of years, which really makes you wonder if they’re really going to happen at all,” said Peter Morici, an economics professor at the University of Maryland.

The prospect of spending cuts is the last thing the U.S. economy needs right now, many commentators say.

Economists were stunned on Friday when data showed the U.S. economy grew just 0.4 percent in the first three months of this year — perilously close to contraction — and picked up unimpressively to 1.3 percent in the second quarter.

Against the backdrop of the weak economic recovery, the divided political parties in Congress appear to have agreed on one thing early on in their dispute over how to raise the U.S. debt ceiling: that spending cuts to narrow the deficit should be phased in slowly. They will be phased in from 2013.

President Barack Obama told reporters on Sunday that the initial discretionary cuts, expected to be about $917 billion, “wouldn’t happen so abruptly that they’d be a drag on a fragile economy.” He added that “job-creating” investments in education and research would be preserved.

But the bulk of the austerity has yet to be defined.

About $1.5 trillion of the planned savings will be decided by a bipartisan congressional commission, leaving unanswered the question as to whether the United States has the political will to tame the country’s growing debt pile once and for all.

Troy Davig, U.S. economist at Barclays Capital, estimated that the deal would only cut $25-30 billion from government spending in the first year, which could shave about a tenth of a percentage point off economic growth.

“It’s not a major drag on growth but when the economy is only growing a point and a half, a lot of economists feel that this is not the right time to be finding fiscal restraint. We will be shifting from massive stimulus to massive restraint.”

Steeper and faster spending cuts could have dealt a knockout blow to an economy reeling from high fuel prices, bad weather, Japan’s earthquake and a depressed housing market, plus a labor market that shows few signs of recovery.

LITTLE SCOPE FOR STIMULUS

Proposals discussed just a week ago included possible new fiscal stimulus measures, such as extending payroll tax cuts for employees and offering them to employers as well.

There appeared to be no room for them in Sunday’s preliminary deal which is expected to be voted on in the Senate on Monday and sent to the House of Representatives for approval. The bipartisan panel, which must draft more cuts by November, could revisit the issue.

There could be some relief among U.S. employers and consumers that taxes won’t rise under the new, hard-fought deal and that the worst-case scenario has been avoided.

The talks have been punctuated by warnings from the Obama administration that financial chaos would ensue if the $14.3 trillion federal borrowing limit is not raised by Tuesday.

That angst has added to a pile of worries slowing consumer spending decisions such as car purchases, according to Detroit executives. Existing home sales in June fell sharply due a big jump in canceled sales contracts.

Obama, too, said he has been concerned about the debt limit battle’s impact on consumer and business confidence. He said he hoped Sunday’s deal “will begin to lift the cloud of debt and the cloud of uncertainty that hangs over our economy.”

Any relief, however, is likely to be short-lived. U.S. jobs data on Friday will probably prove another reminder of the weak U.S. economy. Unemployment is expected to remain at 9.2 percent, according to a Reuters poll.

The budget deal “does nothing to restore household and corporate confidence,” said Mohammed El-Erian, chief executive of bond fund investment giant PIMCO.

“So unemployment will be higher than it would have been otherwise, growth will be lower than it would be otherwise, and inequality will be worse than it would be otherwise,” El-Erian told ABC’s This Week with Christiane Amanpour.

Just as Washington’s political leaders have run out of money to throw at the U.S. economy, the Federal Reserve looks lacking in ammunition too.

The U.S. central bank waged an massive experiment in monetary policy over the last few years to prevent the 2007-2009 recession from spiraling into a depression, slashing interest rates to zero and pumping $2.3 trillion into the ailing economy by buying debt,

The Federal Reserve is not expected to rush in to make up for the loss of any stimulus to boost growth.

Atlanta Federal Reserve President Dennis Lockhart said on Friday there would be a “very high bar” for more stimulus.

At least the deal taking shape in Washington would push the scary prospect of a U.S. debt default out until after the 2012 presidential election. But investors worldwide will still worry about the ability of the United States to avoid future downgrades of its debt, a move that would probably push up borrowing costs and act as yet another drag on the economy.

“Talk about kicking the can down the road, this is probably the biggest can that’s ever been kicked — appointing another commission to do the heavy lifting another day,” Yale University economist Stephen Roach told Reuters Insider.