Government Spending Cuts to Fuel U.S. Economy Ignore Math of Lost Growth

Advocates of reduced federal spending say shrinking the U.S. government would boost the economy and create jobs. They are wrong, according to Wall Street economists -- at least for the short term.

House Republican leaders, including Speaker John Boehner, urge spending cuts to lift employer confidence and increase investment and hiring. President Barack Obama, who signed into law a stimulus program now valued at $830 billion, has echoed the Republican assertions in recent comments, even as he has resisted cuts as deep and fast as they want.

Professional forecasters beg to differ. Fiscal retrenchment could subtract 1.5 percentage points to 2 percentage points from growth in 2012, a drag that will make it difficult to reduce 9.2 percent unemployment, say economists at Bank of America Merrill Lynch, JPMorgan Chase & Co. and Deutsche Bank AG.

Federal Reserve Chairman Ben S. Bernanke this week cited similar concerns. “You need to be careful about sharp cuts in the very near term” because “the economy is still growing very slowly,” he told the House Financial Services Committee in Washington. “To the extent possible, we should make the cuts over a long term because this is a long-term problem.”

Bernanke cited the drop in federal, state and local government payrolls of 39,000 jobs in June, offsetting most of a 57,000 gain in hiring by companies. The unemployment rate rose to 9.2 percent, its highest this year, Labor Department data showed July 8.

Significant Headwind

“Fiscal consolidation is rarely pain-free,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York, who predicts the economy will grow 2.8 percent next year. “It is obviously a significant headwind. We are looking for a very slow decline in unemployment.”

David Rosenberg, chief economist at Gluskin Sheff & Associates Inc. in Toronto, said government cutbacks could lead to a “growth recession,” with expansion so slow that the unemployment rate continues to rise.

“This morphing from fiscal stimulus to fiscal restraint is going to prove to be a very big swing,” he said. “All those people out there that are talking about the necessity of cutting spending and massive fiscal restraint is a case of ‘be careful what you wish for.’ ”

An outright contraction can’t be ruled out with the economy growing slowly, said Dominic Konstam, New-York based head of interest-rate research at Deutsche Bank.

U.S. growth of 1.9 percent in the first quarter was followed by an estimated 2 percent gain in the second, according to a Bloomberg News survey of 60 economists this month. The median estimate for 2012 is 3 percent.

Risk of Recession

“If we’re going to get any kind of fiscal tightening, then the risk is you’ll have a recession if all you can do is grow around 2 or 3 percent without the fiscal tightening,” Konstam said.

Republican House leaders say spending cuts will produce growth.

“The best thing we can do is to have real spending cuts” to “provide some confidence to job creators in America,” Boehner said July 11. Representative Jeb Hensarling of Texas, the fourth-ranking House Republican, said on July 7, “we’ve got to cut the spending if we want to increase the jobs.”

Chief executive officers were less optimistic about the U.S. economy, according to a survey released June 14 by Business Roundtable, an association of corporate leaders. The association’s economic outlook index fell to 109.9 in the second quarter from 113 the previous three months.

‘Balanced Approach’

Obama has called for a “balanced approach” to the nation’s growing debt that would include higher tax revenue and spending cuts. At the same time, he has echoed Republicans’ assertion that reduced outlays would stimulate the economy by giving employers confidence.

Obama, in a July 2 radio address, said, “we have to cut the spending we can’t afford” to “give our businesses the confidence they need to grow and create jobs.”

The comments drew a rebuke from Nobel Prize-winning economist Paul Krugman, who said in a Web posting that the president was embracing “the myth of expansionary austerity and the confidence fairy.”

Spending cuts are likely to hurt the recovering economy more than raising taxes, said Christina Romer, who was Obama’s first chairman of the White House Council of Economic Advisers.

“The economics literature is pretty strong that if you think about both the short-run effects of tax increases or spending cuts and the long-run incentive effects, I think tax increases do less damage to the economy than some of the spending cuts,” she said.

Stimulus Package

Government spending contributed a combined 1.1 percentage points to growth from 2008 to 2010, as the economy overall grew 0.3 percent, according to the Bureau of Economic Analysis. Growth was supported by Obama’s stimulus package, which was criticized last year by House Republicans as ineffective.

Boehner doesn’t buy the thesis that spending cuts crimp growth in the short run, said his spokesman, Mike Steel.

“This is the same sort of argument that was used to sell the stimulus spending binge” of the Obama administration, “with claims it would keep unemployment below 8 percent,” Steel said in an interview yesterday. “Unemployment now is 9.2 percent.”

“At a time we are borrowing 40 cents out of every dollar the government spends, every serious economist has called for a real plan to deal with our debt and deficit,” he said.

Concerns about budget deficits haven’t pushed up U.S. Treasury yields, even after Moody’s Investors Service warned this week that a stalemate in talks to raise the debt ceiling could jeopardize the nation’s credit rating.

10-Year Yield

The yield on the 10-year Treasury note was 2.95 percent late yesterday in New York, compared with an average 5.38 percent since the start of 1990.

Federal Reserve policy makers, at their June 21-22 meeting, cited “a larger-than-expected near-term fiscal tightening” as one of the “downside risks” to the economy, according to minutes of the session released this week.

American consumers are contending with falling home values, unemployment hovering close to 9 percent for the past two years, and a jump in fuel prices that sent gasoline costs to the highest level in almost three years.

Consumer spending, which accounts for about 70 percent of the economy, grew at a 2.2 percent annual pace in the first quarter, down from a 4 percent gain in the last three months of 2010. Economists at Morgan Stanley in New York project it expanded at a 0.4 percent rate in the second quarter as auto demand slumped.

Slight Impact

The impact of any boost in business or consumer confidence is likely to be slight compared with lost growth, said Ethan Harris, head of developed-markets economic research at Bank of America Merrill Lynch in New York.

“Confidence-building type effects, even in a well designed plan, can’t make up for the loss of actual spending,” he said. “It makes it hard to get a solid year next year, even with the rebound from the various shocks this year.”

Alan Blinder, a Princeton University economist and former Fed vice chairman, said he has “tried to debunk the notion that more government spending kills jobs.”

“I don’t find it realistic to think that a boost from confidence would make up for a significant fiscal contraction,” he said. “Fiscal contraction, per se, will reduce aggregate demand.”

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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