Fear of Spending Cuts: Automatic Cuts Seen by Some as Threat to U.S. Economy

November 18, 2011 - 4:10 AM
Debt Supercommittee

Supercommittee member Sen. John Kerry, D-Mass. meets with reporters on Capitol Hill in Washington, Thursday, Nov. 17, 2011, as he and fellow Supercommittee members emerged from a closed-door meeting. (AP Photo/J. Scott Applewhite)

WASHINGTON (AP) — Just as the U.S. economy is making progress despite Europe's turmoil, here come two new threats.

Deep spending cuts are set to kick in if a congressional panel can't agree by Thanksgiving on how to shrink the budget deficit. And Congress may let emergency unemployment aid and a Social Security tax cut expire at year's end. Either outcome could slow growth and spook markets.

Analysts are concerned. Yet most aren't panicking.

Many say the economy and markets can withstand the blows. That's because Congress or the Federal Reserve could take other steps next year to blunt the automatic cuts and lift the economy. And investors expect so little from the congressional panel that they're unlikely to overreact if no deal is reached.

"There's no doomsday scenario in reducing government spending," said David Kelly of JP Morgan Funds.

The 12-member bipartisan panel, or supercommittee, was created in August to defuse a political standoff over raising the federal borrowing limit. It's supposed to find at least $1.2 trillion in deficit cuts by Nov. 23. If it fails, federal spending would automatically be cut by that amount over nine years, starting in 2013.

The law triggers cuts in programs prized by both parties: social services such as Medicare for Democrats, defense spending for Republicans.

The panel appears to be deadlocked.

Economists say a stalemate makes it harder for Congress to extend the Social Security tax cut and unemployment benefits. On the other hand, if the supercommittee does forge a deal, it might include an extension of those benefits. Or it could at least clear the way for an extension later.

The Social Security tax cut gave most Americans an extra $1,000 to $2,000 this year. Unemployment benefits provide about $300 a week. Most of that money quickly and directly boosts consumer spending, which drives the economy.

By contrast, an expiration of those benefits could cut growth by about three-quarters of a percentage point, economists say. Throw in other cuts, like those passed in the August debt deal, and all told, federal budget policies could subtract 1.7 percentage points from growth in 2012, according to JPMorgan Chase and Moody's Analytics.

Given the tepid economy, such a hit could be damaging.

"It would be very difficult for an economy that's doing well to digest, let alone one that's barely growing at potential," said Ryan Sweet, an economist at Moody's. "That could unwind a lot of the improvement we've seen so far."

The economy grew at an annual rate of 2.5 percent in the July-September quarter. Some analysts fear it could fall below 2 percent next year, especially if the emergency unemployment benefits and Social Security tax cuts aren't renewed.

The U.S. economy faces other threats, too — from persistently high unemployment to Europe's spreading debt crisis, which could hasten a recession.

If the automatic spending cuts take effect, the defense budget could be cut by nearly $500 billion over nine years. Some contractors are nervous.

Wes Bush, CEO of Northrop Grumman, has told analysts that the company is bracing for spending cuts.

"It's certainly going to be a more challenging environment" next year, he said.

Another wild card: Some investors fear that the supercommittee's failure would spark fresh downgrades of U.S. debt. Standard & Poor's downgraded the government's long-term debt in August. That contributed to a stock market plunge. It's possible that a deadlocked supercommittee would lead the two other major rating agencies — Fitch and Moody's — to follow suit.

Yet S&P's downgrade did little to tarnish U.S. debt. Treasury prices rose, and yields fell. Bond investors still saw Treasurys as a super-safe investment. Federal borrowing costs actually declined.

"S&P showed that when a rating agency downgrades the best-known security in the world, it has little impact," Kelly said. The market for U.S. Treasurys is so broad, accessible and transparent that ratings downgrades don't pose much threat, he noted.

Kelly said Wall Street is unlikely to panic given that expectations for the supercommittee "are so low as to be subterranean."

Even so, some traders appear to be positioning for a shock. So-called "defensive" sectors of the stock market, like healthcare companies and utilities, which tend to retain their value in a weak economy, have been outpacing the S&P 500 index as a whole.

In the past month, the economy has shown surprising strength. Reports this week showed that manufacturers are producing more goods and consumers are spending more. The number of people seeking unemployment benefits for the first time is at a seven-month low.

Still, more than once since the recession officially ended more than two years ago, the economy has displayed vigor only to stumble again. High gas and food prices and Japan's earthquake sharply slowed growth in the first half of the year. Congress' debt-ceiling fight sent consumer confidence to recession levels.

Sweet thinks there's a good chance Congress will end up extending the Social Security tax cut. Partly on that assumption, Moody's foresees 2.6 percent growth next year. For this year, analysts generally estimate less than 2 percent growth.

Lawmakers could make other policy changes next year to energize the economy. The tax cuts enacted during the Bush administration, and extended in 2010, are set to expire after 2012. Republicans will push to renew them.

Some of the automatic cuts set to kick in in 2013 could be delayed or altered. That's particularly true if the White House or either chamber of Congress changes sides in 2012.

And some economists say the automatic spending cuts could actually boost confidence a bit: They would reassure the world that the U.S. government can make progress in shrinking its deficit.

Even so, the supercommittee seems likely to fall short of its goal to help reduce the federal debt load.

And there's more pressure to come.

Priya Misra, an analyst at Bank of America Merrill Lynch, estimates that Congress will need to find $2 trillion more in cuts by August 2013 to prevent another credit downgrade.