US debt deal will hold back its economy

Updated: 2011-08-03 11:26

By John Ross (

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The outcome of the negotiations between President Obama and congressional leaders on the US federal debt ceiling is a Republican policy victory. But it will do nothing to solve the US economy's problems, which were reflected in the slow growth revealed in GDP figures published immediately prior to the debt agreement. Because the outcome will not raise US growth, and eliminates the possibility of a fiscal stimulus, it increases the risk of a new round of US quantitative easing to attempt to kick start its economy. This would increase inflationary pressure in China and other countries. If US growth continues to be slow it is also uncertain whether the debt deal will actually significantly reduce the US budget deficit – in particular, slow growth means potentially lower than anticipated increases in tax revenues.

The deal's political parameters are clear. President Obama called for a "balanced" reduction in the budget deficit, combining spending cuts with tax increases for the richest US citizens. The Republicans said there should be no tax increases for rich Americans, and the deficit should be reduced solely via cuts in projected spending. The Republican position is reflected in the outcome. As a New York Times editorial put it the agreement is a "nearly complete capitulation to the hostage-taking demands of Republican extremists". Or, as the British Guardian noted: "the principle of spending cuts in the absence of tax raising-measures has been surrendered."

The Republicans, who imposed the deal, were responsible for creating the federal deficit in the first place, thereby making it more difficult for the US to respond to the international financial crisis. As the Guardian's economics editor Larry Elliot noted: "George W Bush took what had been a solid fiscal position inherited from Bill Clinton and trashed it. Two expensive wars and tax cuts for the well-off meant that by the time the subprime mortgage crisis broke the US was saturated in private-sector debt and the public sector balance sheet was in poor shape."

This present debt deal could be condemned morally, as it leaves average and less well-off US citizens poorer in real terms due to spending cuts while protecting the rich. But it is also a bad deal in terms of economic policy.

Growth in the US economy is extremely weak. The recently published 2nd quarter 2011 US GDP figures, showed annualised growth of only 1.3 percent in the quarter. The same data lowered GDP growth in the 1st quarter of 2011 to 0.4 percent and revised downwards the trough of the US Great Recession to a GDP fall of 5.1 percent. US GDP remains 0.4 percent below its peak in the 4th quarter of 2007. Weak growth, in turn, puts upward pressure on the budget deficit primarily by cutting tax revenues but also by increasing welfare payments.

The debt agreement's cuts in projected US government spending will, other things being equal, reduce government and household consumption. Theoretically this could be compensated, as a source of demand for US economic growth, by increases in either net US exports or investment. But this is unlikely to occur, in which case the restrictions on consumption, by reducing overall demand, will depress growth.

To analyse whether these alternative sources of demand can compensate for the restriction on consumption growth it should be noted that the US trade deficit is widening – i.e. net exports are falling. The US trade balance, having reached a low of $25.5bn in May 2011, increased to $50.2bn in May 2011 - the latest month's data. As a percentage of GDP, the deficit on US net exports has risen from a low of 3.4 percent of GDP in the 4th quarter of 2010 to 3.9 percent of GDP in the 2nd quarter of 2011, and the gap is increasing. US net trade, at best, is therefore unlikely to significantly increase GDP and is more likely to reduce it.

US fixed investment still remains, in 2005 constant prices, $388 million below its level at the peak of the last business cycle in the 4th quarter of 2007. Furthermore US fixed investment, in the 2nd quarter of 2011, was only 15.3 percent of GDP. In contrast total US consumption was 88.1 percent of GDP. As consumption is almost six times as high a proportion of US GDP as fixed investment this means that to compensate for a one percent reduction in any increase of consumption US fixed investment has to rise by almost six percent.

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