Going for broke could break fragile economy

The economy has grown so fragile this year that missteps by the warring factions in Congress could tip it back into recession, economists warn.

Growth unexpectedly slowed to a near-halt early this year under the weight of high gasoline prices, a devastating earthquake in Japan and budget cuts at all levels of government, according to a report released Friday that showed growth sank to a paltry 0.4 percent rate in the first quarter.

Congress is now locked in a debate over further deep spending cuts, and the impasse between the two parties is primarily over an increase in the government’s $14.3 trillion borrowing limit.

An agreement between President Obama and congressional leaders that emerged Sunday raised hopes, including in Monday’s early trading in Asia’s stock markets, that the two sides may have finally found middle ground, establishing a two-step process to raise the debt limit, cut spending programs, and reform the tax code in coming months.

But getting compromises through the House and Senate have proved difficult. If the deal is rejected by one or both houses, it raises the risk that the government will reach its borrowing limit Tuesday and will have to start indiscriminately slashing spending on contracts, salaries and benefits to avoid defaulting on its debt.

While much of the debate in Congress has focused on the potentially disastrous impact of a default, economists say an equal danger is that further harsh spending cuts - whether planned or unplanned — could be toxic for an economy that is wobbling precariously close to recession.

“A government shutdown would have a big impact,” said Chris Lowe, chief economist at FTN Financial, referring to the looming cash crunch that could force an effective 40 percent cut in federal spending this month.

He added that the bitter fight in Congress has been detrimental for the economy by zapping confidence and making businesses and consumers more hesitant to spend as they await news of changes in their taxes and benefits.

“What is worrisome” is that growth has been getting progressively slower in recent months, he said. “At this point, growth is so close to zero that confidence is more important than it normally is, and the distraction of the debt ceiling fight could make a big difference.”

Mark Vitner, an economist with Wells Fargo Securities, said the somber portrait presented in Friday’s report, which showed growth in the past year at only 1.6 percent, was a “game-changer” and presented a dilemma for a Congress bent on taming the debt.

“More fiscal restraint, while needed to avert a debt-rating downgrade, does not appear to be a recipe for a stronger” economy, he said. “Growth is well below the 2 percent threshold that has predicted recessions in the past.”

With Congress under pressure to slash spending to avoid a downgrade, Moody’s Investors Services took the unusual step Friday — after the disappointing growth report was released — of pointing out that maintaining strong economic growth is just as important as cutting spending to gain control over the debt.

Stronger growth helps swell the government’s revenues and lower unemployment-related spending, while a fallback into recession would only worsen the budget deficit regardless of congressional action.

“If the economy takes off in 2012 and shows very strong growth,” the U.S. likely would retain its top AAA rating, Moody’s analyst Steven Hess told Reuters news agency, noting that growth “makes the whole process of fiscal consolidation much easier.”

The most imminent danger for the economy is that if Congress fails to pass the leadership compromise, the Treasury this week will start running out of cash to pay the government’s bills.

The Treasury is expected to have enough cash on hand to pay a $23 billion round of Social Security benefits Wednesday, but, without an increase in borrowing authority, it will have to conserve funds to be sure it can make a critical debt payment Aug. 15. That means it may have to selectively defer paying other government bills, including employee salaries, contracts, military and veterans’ pay and benefits, and state and local grant payments.

Economists estimate that the Treasury will have run out of cash by midmonth and will be in danger of defaulting on the debt and otherwise not being able to pay about 40 percent of obligations that come due.

Barclays Capital economists estimate that the biggest blow to the economy would come from such a sudden drop in federal spending, which would affect senior citizens, troops and other consumers who depend on government benefits for their income, as well as contractors and state and local governments that depend on federal payments to make payroll and pay other bills.

The ratings agencies have warned that numerous states and cities could be downgraded if the Treasury starts selectively delaying payments because they depend in part on federal transfers to make payments. Many businesses also could suddenly be unable to pay their own bills and debts if they don’t receive expected payments from the government.

David Greenlaw, an economist at Morgan Stanley, said he is not worried so much about immediate spending cuts because he thinks Congress will enact borrowing authority in time to prevent a lapse in federal payments. He also said the spending-cut plans being discussed by party leaders likely will not do much to deter the economy this year, as the cuts are mostly “back-loaded” into future years.

What does worry him is the looming expiration of payroll-tax cuts and other programs that were enacted at the end of last year to stimulate the economy. They have become “lost in the shuffle” in the debt debate, and they may not be revived, he said. The White House sought an extension of the stimulus measures as part of a “grand bargain” on the debt that never materialized.

That means the economy is headed for a sharp contraction in federal support at the beginning of next year, Mr. Greenlaw said. He said he is also “concerned about the general uncertainty and impact on business and consumer behavior” from the prolonged fight in Congress. Some businesses have put off hiring and investment while they wait to see what happens.

“That’s becoming an increasingly important issue,” he said. “If this drags on for long, you will see more of a headwind for the economy.”

“Even if the debt standoff is resolved quickly this week,” said Nigel Gault, an economist at IHS Global Insight, “the extreme uncertainty will surely already have damaged third-quarter growth by hurting consumer and business willingness to hire and spend.”