Thursday, July 5, 2012

Recent US government spending cuts dampened recovery - further "austerity" may risk recession

In this week's economic report, the IMF described the US recovery as tepid and highly vulnerable to global shocks. This is nothing particularly surprising, but the report discusses in some detail sources of risk to the economy.
IMF: - The U.S. recovery remains tepid. After rebounding in the second half of 2011, growth slowed to around 2 percent in the first half of this year. Strong headwinds persist on private consumption, as households continue to deleverage.
The United States remains vulnerable to contagion from an intensification of the euro area debt crisis. U.S. financial institutions have limited direct claims on the euro area periphery, but strong financial linkages with the core euro area. Financial stresses in the region may affect the United States mainly via a generalized increase in risk aversion and lower asset prices (including for U.S. multinational firms with substantial sales in the euro area) even though safe haven flows would likely reduce yields on safe assets, notably U.S. Treasuries. Lower demand in the euro area would reduce U.S. exports to the region, while U.S. dollar appreciation on safe haven flows would hurt exports more generally.
The IMF also pointed to the "fiscal cliff" uncertainty as one of the developments inhibiting growth.
IMF: - It is critical to remove the uncertainty created by the “fiscal cliff” as well as promptly raise the debt ceiling, pursuing a pace of deficit reduction that does not sap the economic recovery.
In fact it is the broader government belt tightening that has already taken place which is contributing to this weakness - even before the impact of the "fiscal cliff". Here is a comparison of the recent government spending growth (inflation adjusted) to the average of the previous 9 cycles. The initial stimulus has ended and cuts are starting to take effect just when historically in the cycle government spending had been picking up.

X-axis in quarters (source: DB)
DB: - Last quarter, inflation-adjusted federal government spending declined -5.9% after falling -7.0% in the previous quarter. These were the two largest back-to-back declines since Q4 1995 and were predominantly the result of sharp falls in military outlays, ostensibly related to the withdrawal of troops in the Middle East. The drop in government spending reduced Q1 GDP by about half of a percentage point.
Unfortunately the US economy is still very much dependent on a steady flow of federal dollars. Any further disruptions in this flow would severely dampen the recovery process. That is why if not managed appropriately, a combination of spending cuts and tax increases of the "fiscal cliff" could easily tip the US economy into a recession.
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