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Debt deal or not, weak economy is likely to suffer

Posted: July 28, 2011 - 9:19pm  |  Updated: July 29, 2011 - 8:14am

WASHINGTON — No matter how the debt crisis ends, the economy will probably take a hit. The question is how big.

Failing to raise the federal borrowing limit would force the government to slash spending immediately and possibly cause a default, frightening financial markets and sending interest rates up.

If Washington reaches a deal and does raise the limit, it will probably include long-term spending cuts. The cuts would withdraw government stimulus at a time of weak economic growth and damage the already feeble recovery, at least in the short term.

“Pick your poison,” says Ben Herzon, senior economist at Macroeconomic Advisers, an economic forecasting firm.

Macroeconomic Advisers studied the impact of the $2.2 trillion in spending cuts proposed by Senate Majority Leader Harry Reid, D-Nev., and $916 billion in cuts proposed by House Speaker John Boehner, R-Ohio. Both would be spread over a decade.

It estimates Reid’s plan would cut annual economic growth by one-fourth of a percentage point through September 2015. It estimates Boehner’s would shave annual growth by a tenth of a point over the same period.

Neither of those is huge. But economic growth has already slowed to its weakest since the recession ended two years ago.

Federal Reserve Chairman Ben Bernanke and other economists agree that cutting the government’s massive debts is critical to the long-term health of the U.S. economy. Republicans argue the cuts should be imposed sooner.

But many, including Bernanke, worry about cutting so soon.

Analysts estimate the economy grew at an annual rate of just 1.7 percent in the April-June quarter, held back by weak consumer spending and high unemployment.

It takes 2.5 percent growth just to keep unemployment from rising, and 5 percent to lower it significantly. Economists foresee only slightly stronger expansion in the current July-September quarter.

“The economy is still fragile and cannot afford a policy mistake,” economists at Bank of America Merrill Lynch wrote in a research note last week.

The gravest outcome, most agree, would be failure to reach any deal to raise the debt ceiling before the government runs out of money to pay all its bills. The Treasury Department says that date is Tuesday. Some economists say it is several days later.

The government is spending about 40 percent more than it is collecting in taxes. Without a higher debt limit, it can’t borrow any more. So it would be forced to slash spending to match revenue.

The choices would be agonizing. The Bipartisan Policy Center says that if the government kept paying for health care programs, Social Security, unemployment benefits and defense contracts and met interest payments on its debt in August, it would have no money left for anything else.

Under that scenario, civil servants and troops would go unpaid. IRS refund checks would go unmailed. Veterans would lose benefits. The Justice Department would have to scale back its pursuit of criminals.

“That is the worst of all possible worlds,” says Nariman Behravesh, chief economist at IHS Global Insight. “Slashing even for a couple of weeks could do a lot of damage to the economy.”

Bank of America economists have said failure to raise the debt ceiling, followed by sharp cuts in government spending, “risks throwing the economy back into recession.”

There’s also a chance that major credit rating agencies would downgrade the U.S. government’s stellar credit rating even if politicians do reach a deal. The rating agencies might declare the debt reduction inadequate.

A downgrade could force the government to pay higher interest rates on its debts. Rates on everything from cars to some mortgages would increase, too, leaving less money in people’s pockets and further slowing economic growth.

Sherry Cooper, chief economist at BMO Financial Group, says the rating agencies “should refrain from downgrading U.S. debt. ... Clearly, both the Democrats and Republicans are serious about deficit reduction.”

The impasse over the borrowing limit has already taken an economic toll. Some businesses are holding back on hiring or expanding because of the uncertainty created by the crisis, says Mark Vitner, an economist at Wells Fargo Securities.

Economists say the main reason businesses aren’t hiring is weak demand from their customers, not uncertainty in Washington.

Still, that uncertainty is likely to persist — even if a deal is reached, Vitner says, because the cuts Congress is considering wouldn’t significantly address the nation’s long-term deficit burden.

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