What will debt-ceiling deal do to the fragile US economy?

The political deal to raise the debt ceiling averted a fiscal crisis, but a big question remains: Will the cuts in spending help or harm the economic recovery? So far the markets are unimpressed.

Brendan McDermid/Reuters
A trader watches his screen on the floor of the New York Stock Exchange, Tuesday. The S&P 500 turned negative for the year on Tuesday as the wrangling over the US debt ceiling faded and investors turned their attention to the stalling economy.

A political compromise has averted a fiscal crisis, but now another challenge looms as large as ever: how to get the economy growing and creating jobs.

Some economists warn that the newly passed debt deal, by cutting federal spending, will damage an already fragile recovery from recession. Others see the deal as good news for jobs – that reducing the size of government will help revive the spirits of the private sector.

The answer isn't yet clear, but it could be that the reality will be that the fiscal compromise doesn't exert either a big braking effect or a big forward push.

Regarding the “brakes” thesis, the spending cuts outlined in the plan appear to start fairly small, reducing deficit spending by the federal government by perhaps $25 billion in the coming 2012 fiscal year. That's not even one-fifth of 1 percent of a year's gross domestic product.

Although the scale of those cuts could expand – the debt deal calls for lawmakers to bargain this fall over additional fiscal discipline – it appears likely that the scale of spending cuts in 2012 will remain small.

The scenario of a forward push on jobs, meanwhile, had some cold water thrown on it by financial markets Tuesday. The Dow Jones Industrial Average fell about 2 percent, even as the Senate sealed its approval for the spending-restraint package. That was hardly the “relief rally” that many investors hoped for after weeks of tension over whether Congress would agree on a deal to allow more Treasury borrowing while restraining future deficits.

Market analysts attributed Tuesday's dive to concerns about the economy, not to the debt deal itself. But clearly the fiscal progress hasn't been greeted as an economic panacea.

On Friday, the Commerce Department reported that the US economy grew at an annualized pace of just 1.3 percent in the second quarter, according to preliminary estimates. That's lower than forecasters expected and lower than what's needed to reduce unemployment.

Typically, businesses are reducing the amount of labor needed to produce a given volume of goods and services. And new workers are arriving in the labor force. That means that substantial economic growth is needed to bring down a jobless rate that now stands at 9.1 percent.

President Obama acknowledged the concern about jobs in a public statement Tuesday. He praised Congress for approving the budget measure, but called for additional measures to boost job growth, from free-trade deals to patent reform.

He said the protracted debt negotiations themselves may have dampened consumer and business confidence, adding “one more impediment” to economic recovery. In addition to creating uncertainty, the debt talks drew attention to a polarized and gridlock-prone environment on Capitol Hill.

Major business groups, such as the US Chamber of Commerce, have not voiced concern that fiscal restraint will damage economic growth. Rather, the Chamber hailed the bargain as a step toward sound fiscal policy.

But some economists, with an eye on weak consumer demand, have argued that the debt talks are pushing fiscal policy in the wrong direction. Already, state and local governments are cutting jobs, and the effects of the 2009 federal stimulus package are starting to fade out.

“The cuts put in place as part of this deal will modestly slow [economic] growth in the short-term,” writes Dean Baker of the Center for Economic Policy and Research in an analysis of the legislation.

Longer term, the measure could have negative effects as well, as caps on discretionary spending erode federal investment spending. “If the country does not maintain its infrastructure, its research, and adequately support education, it will hurt productivity and slow growth,” Mr. Baker says.

Economists generally agree that government investments can play an important role in economic growth. At the same time, one camp emphasizes that in a debt-driven economic quagmire (like the current one), the solution has to involve scaling back both public and private debts – not repeated attempts at debt-fueled stimulus.

The recovery from a debt-related crisis tends to be a multi-year process, they warn.

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