According to the GDP statistics released on Friday, the US economy has grown at less than 1 per cent annualised in 2011 Q1 and Q2 combined, a rate which is well below its usual stall speed. This is very sharply lower than I expected at the start of the year. Previously, economists were puzzled by the “jobless recovery” in the past few months. Now the mystery has been solved: there was never much of a recovery in the first place. And the solution to the debt ceiling crisis which may emerge in coming days will, in all likelihood, do nothing to help matters.
A budget deal is now rumoured to be within reach in Congress. While this would be much better than the alternative of no deal, it seems clear that the outcome will bear little resemblance to the comprehensive package which Ben Bernanke and many economists have called for. That comprehensive package would introduce credible medium term policy changes to ensure fiscal sustainability in coming decades, while avoiding an excessive tightening in budgetary policy in the short term.
So what does it seem we will get? Precisely the opposite. The most likely deal will see around $1 trillion of government spending reductions starting next year, along with an automatic trigger mechanism to ensure that the scale of tightening is increased in a second round of cuts before very long. Furthermore, these cuts may be legislated in advance to take effect whatever the state of the economy is at the time. This means that if the economy slides back into recession, any emergency fiscal action has been ruled out in advance.
According to JP Morgan, both the House and Senate fiscal packages, from which the compromise is likely to be forged, would involve a tightening in the budgetary stance of some 4 to 5 percentage points of GDP over the next two years. This tightening, however, is only about half of what would be required to ensure that the US attains a position of long term debt sustainability by the latter years of this decade. In other words, the economy seems likely to be hit by a sizeable, early fiscal tightening, while failing to achieve longer term debt sustainability. This seems to be precisely the wrong way round.
Note that this policy mix is becoming more similar to that which has been introduced in the UK, but in many respects it still differs from the UK stance. In Britain, a credible medium term path for fiscal consolidation has been accompanied by a large fall in the exchange rate, and a highly expansionary monetary stance. Admittedly, that mix has, so far, resulted in nothing better than a very sluggish economy. But because the fiscal path has appeared credible, there should be scope for more monetary easing, and even for some near term fiscal support, if that should be needed. Both of these two escape routes are now strewn with difficulties in the US case.
President Obama has suggested that the US may no longer have a triple A political system. Whatever one thinks of that remark, America has certainly not yet managed to come up with a triple A economic policy mix. As a result, the US may now have to contend with a downgrade to the credit rating on its sovereign debt.
Provided that outright default is avoided – and of course that remains a sine qua non – then a downgrade from triple A status to double A status is unlikely to be the end of the world. A good piece of research by AllianceBernstein (summarised here in the Wall Street Journal) argues that similar downgrades have done relatively little damage in several previous examples, including Japan, Canada and Australia. And the continuing strength of the US bond market last week scarcely indicates that financial confidence is ebbing away.
Yet the price of removing its self-created problem with the debt ceiling seems likely to be that fiscal policy will be tightened at a time when the economy is already weakening.
The GDP figures for Q2 were very disappointing from every point of view. Not only did they show that growth so far this year has fallen to only about half the rate required to stop unemployment from rising further, but benchmark data revisions also showed that the 2008 recession was deeper than had previously been thought, and that the recovery since then has been more anaemic than previously believed. (See this piece in Money Supply by Robin Harding.)
As the first graph shows, most of the slowdown in growth has been due to a precipitous drop in consumers’ expenditure growth, which has slowed to about zero in Q2. And, as the second graph shows, 
much of this has been due to the squeeze of real disposable income growth which has taken effect as the impact of rising oil prices has been felt in consumer prices. Economic models of consumer behaviour usually assume that households will be forward looking, so that spending will only be moderately affected by the contemporaneous growth rate of personal incomes. But on this occasion, the squeeze on incomes seems to have had a rapid effect on spending, possibly because many households are now constrained by insufficient access to credit, and remain concerned about excessive levels of personal debt.
The main ray of sunshine in this otherwise troubling situation is that oil prices have now stopped rising, and this should take the pressure off household incomes in the second half of the year. That is now becoming an absolute necessity if the US is to resume its economic recovery in the coming months.
