Comstock Partners, Inc.July 21, 2011
Deficit Deal Could Derail Growth
Since both the Chamber of Commerce and most of Wall Street are strongly urging political leaders to raise the debt limit and avoid a U.S. default, it is likely---but not absolutely certain----that this will happen. Political leaders of both parties realize that defaulting would be a global disaster, and Speaker Boehner today indicated that he can bring enough House Republicans to vote for some sort of compromise even though some members may vote against it. The way events are shaping up, however, it is highly possible that an agreement to raise the debt limit will include provisions calling for significant near-term cuts in spending that will further impede an already weakening economy.
To understand the current state of the economy we again repeat our long-standing view that the main reason why the current recovery is so weak is the lack of the consumers' ability to spend as households build up their savings and pare down debt after decades of using excessive credit. We have published a number of comments showing how key economic series have undergone the worst declines and the weakest recoveries in the post-war period (see archives). An excellent article in last Sunday's New York Times (see www.nytimes.com/2011/07/17/sunday-review/17economic.html) by David Leonhardt, based on a New York Federal Reserve Bank study, explains the nature of the decline in terms of discretionary consumer spending. This is consumer spending excluding outlays on such necessary items such as food, housing and healthcare.
According to the article discretionary spending never fell more than 3% per capita in any recession of the past 50 years, but is now down 7%. As an example, the auto industry, even in this year of recovery is on pace to sell 28% fewer vehicles than ten years ago in 2001 when the economy was in recession. Oven and stove sales are at the lowest level since 1992. The article repeats our long-held contention that business is not hiring because of slack consumer demand since households are facing a sharp downturn in wealth and historically high debts. Since 1980 spending has significantly exceeded income and consumers compensated by reducing savings and running up debt through credit cards, mortgages, home equity loans and cash-out refinancing that used the run-up in home prices. Now those sources of cash are gone and consumers are forced to limit spending.
The weak economic recovery was spurred by the most massive government stimulation in history, both fiscal and monetary. However even this weak recovery has faltered in the first half of the year despite QE2 and some fiscal stimulation. Now QE2 has ended while the fiscal stimulus has gradually been turning into restraint.
This brings us to the problem of what kind of deficit reduction deal will be agreed to in order to raise the debt ceiling and avoid a U.S default. So far it appears that a deficit cutting agreement could very well be based on some form of the "Gang of Six" proposal. This would roughly include $3 trillion of spending reductions along with tax reforms of some kind resulting in about $1 trillion of revenue enhancements.
The major problem for the economy arises from the prospect that a deal that includes large near-term cuts in government spending will add significant fiscal restriction to a fiscal outlook that is already tightening without the deal. And this will happen just as QE2 is no longer in effect. History indicates that further spending cuts to an already weak economy leads to even less growth and even a recession. From 1932 to 1937 the U.S. economy took major steps toward recovering from the depression. However, subsequent fiscal tightening shoved the economy back into a serious depression in 1938. A recent example has occurred in Europe where fiscal restraint has further weakened the economies of the so-called PIIGS.
Therefore while the stock market seems ready to cheer any agreement that increases the debt ceiling and avoids a default, such cheering may be extremely short-lived as the economy sinks further under the burden of additional near-term cuts in spending. This conclusion is based not on any particular political ideology or economic theory, but on the historical record.