Fiscal stimulus doesn’t last forever. At some point, the economic boost from temporary increases in government spending and one-off tax cuts goes away, placing a greater burden on the private-sector to generate growth and create jobs. This time, with the economy still wobbly, the impact could be jarring. The loss of stimulus starting next year will depress economic growth and complicate the Federal Reserve’s efforts to shift monetary policy to back to normal.
Friday’s shockingly weak jobs report highlights the economy’s vulnerability and emphasizes the danger of Washington doing too much budget cutting, too soon. Job growth all but ground to a halt in June, as payrolls increased by a slim 18,000 workers and the unemployment rate rose to 9.2percent. “All in all, an employment report with no redeeming features whatsoever,” says Barclays Capital economist Peter Newland. The labor market’s turn for the worse may even shift the budget negotiations toward the need to extend some current programs or to propose new actions that would provide additional economic stimulus.
When 2012 begins, the economy is already scheduled to lose more than $300 billion in federal support, as several programs aimed at propping up growth in recent years expire or fade away by the end of this year. Policy changes now on the books will result in the most severe fiscal tightening in more than 40 years, subtracting an estimated 1.5 percentage points from GDP growth next year, according to an analysis by economists at J.P. Morgan Chase. That does not include any additional drag from new spending cuts or tax increases that might emerge from the budget talks on Capitol Hill or from cutbacks by state and local governments.
Expiring programs will help to reduce 2012 deficit but at a heavy cost to the economy, especially in the first half of the year. So far the private-sector, which has grown by a modest 2.9 percent over the past year, has not shown the oomph needed to absorb a 1.5 percentage point hit to GDP growth while also supporting a growth rate strong enough to reduce unemployment. For example, for the economy in 2012 to make the mid-point of the Federal Reserve’s 3.3-to-3.7 percent growth projection, private-sector GDP would have to grow 5 percent, a pace not achieved since the tech-stock boom more than a decade ago.
The known drags set to arrive next year start with the expiration at the end of 2011 of the 2 percent reduction in employee payroll taxes. The tax break, which began in January 2011, helped households cope with surging gas prices. Its elimination will be the biggest single burden, soaking workers for an extra $110 billion in withheld taxes beginning in January. The reduction in spendable income will hit consumer spending—and GDP growth—hard in the first quarter.