Economy hums along, proves taxing and spending prognosticators wrong

The U.S. economy has fared better than expected this year after widespread fears that $85 billion of automatic spending cuts and sharp increases in taxes imposed at the beginning of the year would snuff out growth.

The ability to absorb the first round of across-the-board budget cuts is the latest example in which the U.S. economy has displayed remarkable resilience in the face of austerity. Overall, the economy has weathered one of the steepest drops in federal spending on record in the past four years, with spending falling from 25.2 percent of economic output at the height of the Great Recession in fiscal 2009 to a more normal 21.5 percent this year.

Despite the unprecedented withdrawal of massive federal stimulus from the economy, the abrupt withdrawal of $600 billion of tax cuts Jan. 1, and state and local spending cuts of historic proportions in the past five years, the U.S. economic growth has trudged along at a 2 percent average rate since the recovery began in mid-2009. Moreover, many economists think the rate is poised to accelerate to 3 percent in coming quarters despite continuing budget cuts, while they expect revisions of federal economic output figures due out this week to show that the economy has performed more robustly during the recovery than previously thought.

"The economic growth trend in the U.S. stands in stark contrast to the fiscal tightening and slowdown observed in other major global economies," said Steven A. Hess, senior vice president at Moody's Investors Service. The U.S. "has demonstrated a degree of resilience to major reductions in the growth of government spending" not seen in Europe, Japan or other countries struggling with big debts, he said.

Moody's, in a pivotal moment for the U.S. economy, affirmed the Treasury's top AAA rating last week and withdrew a threat to downgrade the U.S. credit rating, citing a dramatic reduction in the budget deficit from a $1.5 trillion peak in 2009 to $640 billion this fiscal year. The rating service cited the economy's solid performance, a surge in revenue resulting from the tax increases, and deep cuts in defense and other discretionary spending programs mostly imposed on President Obama since Republicans gained control of the House and the federal purse strings in 2011.

Lok Sang Ho, an economics professor at Linghan University in Hong Kong, said the data show that the U.S. has handled its economic and financial crisis better than Europe. "The fact is, America is now firmly on a growth path" with its deficit plummeting, while "Europe is still struggling with recession and surging unemployment, with a deficit problem that does not seem to go away."

The U.S. economy's surprisingly good performance "breathes new life into the debate" over whether spending cuts and tax increases inevitably pose threats to growth that political leaders and economists have assumed, said Christopher Papagianis, who was a domestic policy adviser to President George W. Bush.

Rather than faltering in the face of a big dose of fiscal austerity and the "sequester" spending cuts begun in the first quarter, the economy accelerated to a 1.8 percent growth rate from 0.4 percent in the fourth quarter of 2012, and estimates are that growth stayed in the same 1 percent to 2 percent range in the second quarter.

"The policy changes — especially a forecast 5.6 percent cut in discretionary spending — have had virtually no impact on growth rates, but have succeeded in reducing the deficit by $445 billion, or 3 percent," of economic output, he said.

Still growing

The growth numbers fly in the face of what the "hard-core left in the U.S." was predicting, Mr. Papagianis noted. Even many respected economists, including Federal Reserve Chairman Ben S. Bernanke, were bracing for a bigger negative impact on growth and were pleasantly surprised when it did not materialize.

While liberals, who continue to agitate against the automatic cuts, struggle to explain their muted economic impact, "the lesson is important for conservatives to learn as well," Mr. Papagianis said. Tax hikes included in the "fiscal cliff" deal at the beginning of the year have not proved a major drag on growth, either.

"The biggest impact from the move toward austerity was expected to come from the $100 billion increase in payroll taxes" in January, he said. "Many forecasters expected household spending to fall in the first quarter in response to the decline in take-home pay," but the opposite occurred: Consumers increased spending and financed their purchases by using credit cards and dipping into savings.

The moral of the story: It is OK to impose budget cuts and tax increases once economic recovery clearly has taken hold as it has in the past four years, he said.

"Increases in government purchases can serve a useful purpose when the economy is in a state of free fall, as was the case at the beginning of 2009. But the recovery has been underway for four years" and a "proactive deficit reduction" program was the right thing to do at this stage in the cycle, he said.

Political and economic pundits are not the only ones impressed with the economy's resilience in the face of austerity policies. The Fed, which launched a major easing program last year partly in anticipation of the much-feared "fiscal cliff" of tax increases and spending cuts, in recent weeks has signaled that it no longer is so worried about the U.S. recovery and plans to start phasing out its easing programs.

Although Mr. Bernanke continues to advise Congress to focus more of its budget cuts on longer-term spending problems such as the fast-growing Medicare and Medicaid entitlement programs, he has been less strident in his most recent appearances before lawmakers about the danger of premature budget cuts for the economy. One reason Fed officials may be less concerned about the impact on growth is that many expect the government to revise economic growth figures significantly upward when the latest numbers are released Wednesday.

Hidden strength

"There is ample evidence that the economy was growing faster than official statistics showed," said Karl Smith, economics professor at the University of North Carolina at Chapel Hill. For example, he noted a key breakthrough this year when Fannie Mae and Freddie Mac achieved profitability after five years of government conservatorship and a deep housing recession, enabling them to provide the Treasury with a one-time cash dividend of $87 billion that partially repays some of the $190 billion they received in a taxpayer-financed federal bailout in 2008.

The revenue windfall from Fannie and Freddie, which was part of the reason for the big reduction in federal spending and deficit estimates this spring, also provided a powerful clue about the underlying strength of the economy, Mr. Smith said. The strong rebound in the housing market has sent home prices surging and made lending more profitable, while curbing losses from defaults on underwater mortgages backed by the two mortgage financing giants.

Joseph G. Carson, an economist at AllianceBernstein, said the economy's strength is likely to be further revealed Wednesday when the government releases revisions of its gross domestic product report that are likely to increase estimates of growth since 2009 above the sluggish 2 percent average reported thus far.

For one thing, the report will push up estimates of growth in one fell swoop by reclassifying a large category of business spending on research and development as investment spending that contributes to growth, rather than an expense that subtracts from corporate income and profits.

But growth may be revised upward for other reasons as well, Mr. Carson said.

Tepid growth estimates have not jibed with more positive unemployment reports showing a steep drop in the national jobless rate from a high of 10 percent in 2009 to the current 7.6 percent, or with evidence of surging tax revenues, which have grown between 8 percent and 9 percent in the past year.

The strong tax revenue gains come on top of evidence that incomes are growing at a strong 5 percent annual pace, he said, and the combination suggests that the economy has more underlying strength than previously reported.

"In the past, gains of this magnitude in tax receipts have been consistent with annualized growth of at least 5 percent," he said.

Not all economists are as optimistic about growth. IHS Chief Economist Nariman Behravesh said he expects the first quarter's large dose of austerity to have a belated negative impact this year, holding down growth to between 1.5 percent and 2 percent in the second quarter and for the remainder of the year before it gradually accelerates into the 3 percent range next year.

The Congressional Budget Office also continues to forecast that the automatic spending cuts will reduce growth by about a half-percentage point and cost the economy about 700,000 jobs.

"Unfortunately, there is a substantial fiscal drag that will continue through year-end," Mr. Behravesh said.

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