Spotlight on......risks to US growth

Douglas Roberts, senior international economist at Standard Life Investments, says party politics may hamper a return to growth in the US.

Budget deficits are generally associated with economic downturns. Government revenues are hit as lower levels of activity result in reduced tax flows from both households and the corporate sector. At the same time there are usually increased demands on government resources to provide support to ease the burden of lower levels of demand. Generally, this process is short lived and the economy quickly recovers, allowing government finances to re-establish better balance.

Unfortunately, the 2008 economic recession was highly atypical, involving a major hit to the financial system. Such recessions, although rare, tend to be deeper and longer than more ‘normal’ economic downturns.

In the US, revenues collapsed from around 19% of GDP down towards 14%. Government expenditures, in contrast took the strain, jumping from around 20% of GDP to more than 24%. That was a major deterioration. Now, although the recession was officially declared to have bottomed in June 2009, the deficit has shown little signs of amelioration.

The government has felt the need to continue to support the economy through both fiscal and monetary means, unconvinced that the economy had established sufficient momentum to be self-sustaining. As recently as last December, the Bush tax cuts that were due to expire were rolled over.

Although the unemployment rate has eased of late, it still stands around 9%, with close on 14 million still without a job, compared to less than eight million when the recession started. Consequently, the usual ‘correction’ in the deficit has not occurred.

Why can’t it go on?

Governments can generally tolerate budget deficits without any dire consequences, but that is dependent upon the actual level of debt and on the ease with which they can maintain that debt. However, once a deficit exceeds a certain level of GDP it can act as a restraint upon growth. In a widely reported piece of research, Rogoff and Reinhart established that deficits of up to 90% of GDP can be tolerated without any detrimental impact on growth potential – above that and trend growth will be affected. Italy and Japan are prime examples in recent years.

The reason is that the servicing of the debt becomes onerous, and this puts a constraint on spending on other services. In the case of the US, it is estimated that net interest payments and spending on basic entitlements will absorb the whole of the budget by 2030. Such a situation would be harmful to the smooth running of government in a democracy.

On another level, the more onerous the deficit, the greater the possibility that the borrower will default. Although there is no serious suggestion that the US is anywhere near that point as yet, the credit rating agencies have put the US on negative outlook. However, a continued failure to put its house in order could see the US credit rating at risk, which could see its ability to borrow impaired and/or its cost of borrowing rise. The agencies are not just alarmed at the scale of the deficit, but also by the apparent lack of any commitment to rein in the problem.