Only luck can save America's economy

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By Clive Crook

The US economy may not be in recession, but this is the nearest thing. In spite of the recent fiscal stimulus, output grew less than 2 per cent at an annual rate in the second quarter, slower than expected. That followed growth of 1 per cent in the first quarter and a contraction (on revised numbers) of 0.2 per cent in the fourth quarter of 2007. A recession is usually defined as two consecutive quarters of shrinking output. It has not happened yet, but it very well might in the next few quarters. Even if it does not, that would be little consolation.

Prospects for the second half of the year are poor. Some of the current boost from the fiscal injection delivered last quarter will keep feeding through, but consumer spending, the hitherto unstoppable engine of US growth, is stalling. The prices of food and petrol, together with still-tightening credit conditions and a housing market that has not yet touched bottom, are weighing it down. Net exports were the main accelerator in the second quarter - without that rise, in fact, output would have fallen, fiscal stimulus or no. But they cannot be relied on in future because growth in Europe and elsewhere is going to be limited by, among other things, policymakers' worries about inflation.

Most forecasters are expecting a double-dip US slowdown - and the second dip could be a technical recession. Regardless, the labour market is already behaving that way. Unemployment moved up to 5.7 per cent in July, the labour department reported on Friday. Overtime is falling; involuntary part-time working is on the rise. Unemployment will climb above 6 per cent next year. While it may be true that the US has seen much worse, this is no mere "mental recession".

What more can be done? The short answer is nothing. The policy options have narrowed almost to zero. The Federal Reserve has already cut interest rates sharply - more than some think wise - and is having to assure the markets that it is keeping an eye on inflation. In spite of the slowdown, consumer prices are rising at their fastest for almost 20 years. Crucially, this has not embedded itself in expectations of permanently higher inflation. If that happens, and prices start pushing wages, interest rates would have to go up. The recent poor numbers for output and jobs led markets not to expect that interest rates will be cut further, but to hope that they will not be raised again just yet.

Some fiscal room for manoeuvre would be good right now - but precious little remains. The White House just updated its budget forecasts for next year. These pencil in a deficit of nearly $500bn (£253bn, €321bn). This excludes roughly $80bn of war costs. It also makes incomplete allowance for the fiscal component of the various housing-related bail-outs now in train. If Freddie Mac and Fannie Mae (NYSE:FNM) , the housing agencies, are forced to draw on the full support that the Treasury, with the passage of the new housing bill, is empowered to provide, add tens of billions more. A deficit of 5 per cent of gross domestic product next year is within reach.

Looking farther ahead, both presidential candidates are promising to cut taxes by thousands of billions of dollars over the next 10 years (relative to the Bush administration's bogus baseline). Barack Obama, the Democratic contender, is calling for an additional fiscal stimulus right now.

Budget deficits should indeed rise sharply in recessions. In the US, this requires more forceful intervention than in most European countries. Automatic fiscal stabilisers are less powerful in the US: the government is smaller, and the tax base (lacking a value-added tax or equivalent) is less cyclically sensitive. States have to comply with semi-binding balanced budget rules as well, which perversely tighten fiscal policy during recessions. California, in the midst of the current slowdown, has been forced to sack thousands of workers and put state employees on the minimum wage.

Even so, further aggressive fiscal easing at the federal level would be risky. If the budget outlook starts to scare the markets and interrupt the flow of foreign capital to the US, the dollar might fall abruptly - worsening the inflation risk and forcing the Fed's hand on interest rates. The point at which fiscal easing becomes self-cancelling may not be far away.

It is worth remembering where the blame for this neutering of fiscal policy lies: squarely with the Bush administration. At the start of this decade, the budget stood in surplus to the tune of 2.4 per cent of GDP. On unchanged policy, this was expected to grow to a surplus of 4.5 per cent of GDP by 2008. This year's actual deficit of 3 per cent of GDP therefore represents a worsening of more than 7 per cent of GDP, or roughly $1,000bn. Almost all of this deterioration is due to policy: to tax cuts, spending increases, and their associated debt-service costs.

That projected surplus was a priceless gift to the White House. It offered the Bush administration ample scope for outlays on homeland security and other unforeseen priorities, and moderate tax cuts as well, all within a budget balanced over the course of the business cycle. Instead, the administration knowingly opted for outrageous fiscal excess - adding insult to injury with its phoney tax-cut sunset provisions, designed for no other purpose than to disguise the long-term fiscal implications. Eight years on, this startling record of fiscal irresponsibility has all but taken fiscal policy off the table as an available response to the slowdown.

The US economy had better have luck on its side. Luck is about all it has left.