Small spending cuts to have little economic impact

Associated Press
Specialist Michael Pistillo, left, works at his post on the floor of the New York Stock Exchange Monday, Aug. 1, 2011. (AP Photo/Richard Drew)
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WASHINGTON (AP) — The deal reached by Congress to raise the debt ceiling and cut more than $2 trillion in public spending will probably have only a minor impact on the economy for the next two years.

Almost all the cuts would be made in 2014 or beyond. The approach heeds a warning by Federal Reserve Chairman Ben Bernanke and many private economists: Cutting too much too soon could harm the weak economic recovery.

Yet the deal won't do much to help the economy either, economists said, at least in the short term.

Under the debt deal, discretionary spending, which excludes Social Security, Medicare and Medicaid, would be cut $21 billion in 2012 and $42 billion in 2013, according to an analysis by the Congressional Budget Office.

Combined, the cuts will amount to about two-tenths of 1 percent of the economy's total output during the two years. The impact "should be relatively minor," says Brian Gardner, senior vice president at Keefe, Bruyette and Wood, an investment bank.

The spending cuts would increase to $75 billion in 2015 and $156 billion in 2021, the CBO estimates.

Overall, the first phase of cuts would reduce spending by $917 billion over 10 years. A congressional committee would decide on a second phase of cuts totaling $1.5 trillion.

Reduced government spending could less money for highway construction, housing assistance, government-sponsored scientific research or any number of other federal programs.

Companies that work on Defense Department contracts could suffer, too. The stocks of Lockheed Martin Corp., General Dynamics Corp. and Raytheon Co. all sank about 1 percent Monday.

If lawmakers fail to reach a deal on a second round of cuts, the Pentagon's budget would be cut automatically by about $500 billion. That measure is designed as a threat, to make sure congressional negotiators have strong incentives to compromise.

Delaying the deepest cuts buys time for the economy to recover. Right now, it can't absorb shocks very well: Unemployment is still 9.2 percent, people are spending less, worker pay has stagnated, and economic growth is the slowest since the end of the recession in June 2009.

Worries about the economy, including the weakest manufacturing in two years, were one reason the stock market couldn't sustain a rally after the debt deal was struck. The market was flat Monday.

The Federal Reserve meets next week, and economists will watch for any signs the Fed is ready to take new steps to help the economy. It could re-invest its bond holding indefinitely to keep interest rates down.

The debt deal could restore some confidence among individuals and businesses by removing the fear that the U.S. government would default on its debt for the first time, says Troy Davig, an economist at Barclays Capital.

Overall, the deal could subtract about 0.2 percentage point from economic growth in 2012, Davig estimates. While that is a relatively light blow, the economy only grew at an annual rate of 1.3 percent in April, May and June.

In the first three months of the year, the economy grew even more slowly, at a rate of 0.4 percent. The third straight quarterly drop in government spending contributed to the slower growth.

While Bernanke and other economists had warned against cutting too much in the first few years, they also urged Congress to reduce spending over the long term, arguing that solidifying the nation's finances would help the economy.

"Bernanke will be pleased at least with the direction of the agreement," says David Jones, chief economist at DMJ Advisors, a Denver economic consulting firm. "There are no major cuts in the early years but at least a determination to make significant cuts over the 10 years of the deal."

Democratic lawmakers favored smaller cuts over the next two years to avoid hurting the fragile economic recovery, said staffers from both parties with knowledge of the negotiations. Republicans wanted upfront cuts totaling tens of billions of dollars more. The staffers spoke on condition of anonymity because they were not authorized to discuss the negotiations.

Republicans insisted on cuts in exchange for allowing an increase in the limit on how much money the government can borrow. Without the increase, the government would not have been able to pay all its bills after Tuesday, the White House said.

While the deal enables the government to avoid a default, credit agencies could still downgrade their ratings of U.S. debt. That would make it more expensive for the government to finance its debt, and lead to higher interest rates for everyone.

There is little in the debt package to promote economic growth, economists say. A "grand bargain" with reforms to the tax code, cuts in entitlement spending and more long-term deficit reduction would have put the U.S. debt on a sounder footing, they say.

Some other measures meant to stimulate the economy expire at year's end. For example, a 2-percentage-point cut in the Social Security tax that will give most American households $1,000 to $2,000 to spend is set to expire after this year.

Obama wants to extend the Social Security tax cut, White House spokesman Jay Carney says. That could prove difficult with a committee focused on finding up to $1.5 trillion in budget cuts at the same time.

Michael Feroli, an economist at JPMorgan Chase, forecasts that cuts in federal spending and the end of the tax cut could reduce economic growth by 1.5 percentage points in 2012.

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AP Business Writers Martin Crutsinger and Daniel Wagner contributed to this report.

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