Can The Economy Grow Without Government Stimulus?

With Europe still reeling from the Greek debt crisis, and the conclusion of US stimulus programs recalling a similar scenario in the 1930s, risk of another recession is …

With Europe still reeling from the Greek debt crisis, and the conclusion of US stimulus programs recalling a similar scenario in the 1930s, risk of another recession is growing in many countries. Recognizing that budget-tightening measures could backfire and trigger stock sell-off, President Obama recently cautioned fellow G-20 members against restricting economic growth. See the following article from Money Morning for more on this.

The odds of slower economic growth or even a double-dip recession are increasing as industrial countries, led by the United States & United Kingdom, embark on the most aggressive government spending cutbacks and tightening of fiscal policy in four decades.

As they reduce or eliminate stimulus programs installed in reaction to the Great Recession that began in December 2007, governments are gambling they can pare debt without strangling an economic recovery.

Nations will reduce their primary budget deficits, excluding interest payments, by 1.6 percentage points next year, the most since the Organization for Economic Cooperation and Development (OECD) began keeping records in 1970, according to JPMorgan Chase & Co. (NYSE: JPM) economists. The budget squeeze will lop 0.9 percentage point off growth in 2011.

“There’s going to be a meaningful deceleration in growth, but it will still be solid,” Bruce Kasman, the New York company’s chief economist told Bloomberg News.  He forecasts the global economy will expand at a 2.8% annual pace in the first half of next year, down from 3.8% in the quarter that just ended.

Investors have been shedding risk by selling stocks, partly on concern governments will overshoot on spending cutbacks and send the global economy into a tailspin. The MSCI World Index had fallen 16.5% to 1,036.62 on July 2, and the Standard & Poor’s 500 Index was down 16% to 1,022.58 from its year-to-date April highs.

President Barack Obama warned his counterparts at the recent G-20 meetings to be wary of spending cutbacks. The meeting emphasized the countries’ focus on achieving “growth friendly” fiscal policies while acknowledging that leaders must reduce the budget deficits.

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U.S. gross domestic product (GDP) will be reduced by 1.3 percentage points next year when Obama’s $787 billion stimulus program expires. That compares with a drag of 0.7 percentage point in the euro-area and 2.4 points in the United Kingdom, according to JPMorgan estimates.

Kasman described the fiscal tightening in the U.S. next year as “passive,” the result of ending the stimulus package Congress passed in February 2009, shortly after Obama took office. The government says it already has parceled out $415 billion, or 53%, of the program, which includes tax cuts and expenditures on roads and other infrastructure projects.

The U.S. housing market is already reeling from the expiration of an $8,000 tax credit at the end of April, which pushed May purchases of new U.S. homes down 33% to the lowest level in records going back to 1963, the Commerce Department reported.

Miami-based Lennar Corp. (NYSE: LEN), the third-largest U.S. homebuilder by revenue, said sales were down 20-25% percent in June compared with a year earlier.

The chance of United States relapsing into a recession will rise to one in three from one in four if Congress fails to extend unemployment benefits and provide federal aid to states as Obama has requested, Mark Zandi, chief economist at New York-based Moody’s Analytics told Bloomberg. Obama also might opt to phase in tax increases for the wealthy that are due to kick in next year to cushion their impact on the economy, he said.

There is a 30% chance of renewed recession in the United Kingdom and a 35% risk in the euro-area, Howard Archer, chief European economist at IHS Global Insight Inc. (NYSE: IHS) in London told Bloomberg.

“A double-dip can’t be ruled out,” he said.

Eurozone governments, spooked by the Greek debt crisis, are also implementing cutbacks that could hurt economic growth, economists said.

The United Kingdom’s new coalition government last month called for higher taxes and the deepest spending cuts since World War II to slash its deficit. German Finance Minister Wolfgang Schaeuble proposed spending reductions on July 4 that will reduce the country’s federal budget deficit by about 40% over the next five years.

The tighter policies will shrink the German deficit by a percentage point of GDP in each of the next two years from 4.3% in 2010 and reduce the United Kingdom’s gap to 7.4% next year from 9.7% this year, economists at Barclays Capital project.

Some analysts are comparing the present situation to the 1930s, when the U.S. government prematurely cut back on stimulus and raised interest rates, precipitating a major recession in 1937 and ’38.

“In ’37, thinking that the economy was well on the way to recovery, the government began to run a surplus. The Federal Reserve raised the basic interest rate on bank loans, and they raised the reserve requirement for banks. Consequently, they put the economy into a very significant tailspin,” said Fred Carstensen, a professor of economics at the University of Connecticut and executive director of the university’s Center for Economic Analysis.

“Now we appear to be in a replay of 1937, but the economy has not recovered in any way as it did in 1937. We have a very anemic recovery with states in deep trouble and high unemployment… By failing to really push short-term recovery on the argument that it’s too expensive, we are actually likely to increase our total long-term deficit,” he said.

This article has been republished from Money Morning. You can also view this article at
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