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Weak GDP: an economy on edge

The latest gross domestic product (GDP) data shows the US economy's recovery has come to a virtual stop.

GDP grew at an annual rate of less than 1 percent in the first half of 2011. Revised government data show that the recession was deeper - and the recovery has been weaker - than previously thought. GDP grew by 0.4 percent in the first quarter of 2011 and by 1.3 percent in the second quarter - and given that the first quarter's number was revised downwards substantially, there's a good chance that the second quarter's will be too.

The financial crash of 2008, and the subsequent sharp drop in economic output, effectively showed that the model of growth for the prior two decades was no longer sustainable. This model was based on consumer spending, government spending and lots of credit - both private and public. Stagnation in productive industries was ignored as the economy relied on these other sources of growth. A credit-heavy economy meant that the crisis would take the form of a financial crash, but all the focus on finance concealed the roots of the problem: a lack of profitability in productive areas.

The crash and recession thus posed a challenge to this growth model. But, upon entering office in early 2009, the Obama administration did not meet this challenge. It did not seek to put the economy on a different footing.  Instead, its stimulus package was an attempt to resurrect the house of cards: propping up consumer spending (for example, "cash for clunkers" - that is, trading in old cars) and the financial sector (for example, the TARP bailout for the banks and other measures). 

The latest data indicate how this approach has reached its limits, just two years later. Consumer spending, no longer receiving artificial stimulation, has been flat. This would not matter so much if consumer spending did not still represent the largest segment of the economy. Business investment and exports are up, but they are too small relative to consumer spending to make a significant difference overall. The US is paying the price for not restructuring its economy away from consumption.

Similarly, the latest data also show that government spending is becoming a drag on growth. While there was much attention on the 2009 federal government stimulus program, total government spending was flat, because the federal spending only offset the cutbacks at the state and local levels. But now that the federal program is coming to an end, fiscal policy is going to be restrictive. Again, this wouldn't be such a problem if the US economy did not rely so much on government spending in the absence of widespread dynamism.

It's now the case that the US economy is teetering on the edge of a double-dip recession, or even a depression. And if it does happen, the political class is unlikely to have the same counter-crisis mechanisms it used in 2008 and 2009 at its disposal. Monetary policy is stretched: interest rates are near zero, and Federal Reserve quantitative easing is at its limits. And fiscal policy is also stretched: after the 2009 stimulus did not appear to work, and the resulting high level of deficit, there is no political appetite or will for further spending.

The weak GDP numbers put the current negotiations over the debt ceiling in some context.  Slow growth during this recovery phase has meant that the tax revenues are not increasing as much as expected, and the deficit has remained relatively high. If robust growth were to take off, then we wouldn't be having discussions about deficits, as the growth will more or less take care of the problem. But right now, both Republicans and Democrats are focused on deficits and debt, and having nothing to say about growth. 

With or without a default, the economy has been revealed to be weak. If a default happens, and it triggers a downturn, it won't be because of the default per se, but because the economy is already vulnerable. If there is no default, we still face the possibility of a severe contraction. 

A variety of factors - economic and political - that have combined to create this current fix. In particular, in the US (and Europe) we are paying the price for a "muddling through" approach and a failure to face up to structural causes of the 2008 crisis. The politicians have tried to avoid hard choices, but unaddressed issues have a way of coming back.

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