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Huge cuts could imperil recovery, economists say

By Megan Woolhouse
Globe Staff / August 3, 2011

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The massive federal spending cuts that will follow the deficit reduction deal could further weaken a national economy that has been rapidly losing momentum, economists said.

While few forecast an imminent downturn, they said the withdrawal of hundreds of billions of federal dollars comes at a bad time. Over the past few months, hiring has ground almost to a halt, the unemployment rate has resumed an upward trend, and overall economic growth has been barely positive.

Yesterday, the Commerce Department reported that consumer spending, which accounts for more than two-thirds of the nation’s economic activity, fell for the first time in nearly two years.

“That was a surprise it was so bad,’’ said Kenneth Rogoff, a Harvard economics professor. “If consumption is weak, what are businesses going to do? We’re certainly at a vulnerable point.’’

Stocks plunged yesterday on fears of a weakening economy, with the Dow Jones industrial average losing more than 265 points. It was the eighth consecutive day of declines, the longest losing streak since October 2008, during the financial crisis.

Persistently high unemployment above 9 percent and a fear of additional job losses also weigh heavily on consumers, who dramatically reined in their spending; between May and June, the nation’s savings rate rose from 5.0 to 5.4 percent. The weak economy, further hurt by a stagnating housing market, has raised concerns that the nation could slip into a second, or double-dip, recession.

The last double-dip recession occurred in 1981 after the Federal Reserve pushed short-term interest rates as high as 20 percent to fight runaway inflation. However, several economists said the nation’s current economic situation bears more likeness to a period leading to the recession of 1937-38, which came on the heels of the Great Depression.

In both cases, lawmakers and policy makers, concerned about government deficits, took steps to curb federal spending when the economy was still weak.

Gary Richardson, an economist at the University of California at Irvine and a scholar of the era, said unemployment rates soared to 19 percent in the year after the Roosevelt administration raised taxes and cut government spending and contracts as a way to solve the country’s long-term deficit problem.

“Sadly in the last three days we have repeated the biggest policy mistake of the Roosevelt administration . . . cutting government expenditures in the midst of prolonged high unemployment,’’ he said. “It’s certainly not going to help the recovery.’’

Richardson said political leaders have failed to address the long-term economic questions, such as whether the government can continue to fund Social Security and Medicare benefits at promised levels.

Rogoff also said the budget resolution was “very unsatisfying because all the hard decisions are left ahead.’’ He added that the budget battle diminished both Congress and the president’s stature, and could undermine business, investor, and consumer confidence. It needed to push the recovery forward.

“I don’t think the cutbacks are as big a problem as the process - and that was a disaster,’’ Rogoff said. “What really bothers me is that the whole process is a constitutional crisis that makes the US Congress look like the Italian parliament. And that’s not good for growth.’’

A recession begins when broad economic activity contracts, and continues to contract over several months. The Commerce Department reported last week that the economy barely expanded in the second quarter, growing at a 1.3 percent annual rate.

Economic growth after financial crises is often slower than recoveries that follow more typical recessions, said Rogoff, who studied 800 years of financial crises and is coauthor of the book “This Time is Different; Eight Centuries of Financial Folly.’’

Referring to the recent economic collapse that began in 2007, he said calling it the Great Recession is misleading - “like saying it’s a bad cold when you have pneumonia.’’ He said it typically takes about four and a half years before per capita income returns to prerecession levels. “That’s about the track that we’re on at the moment,’’ Rogoff said.

Eugene White, an economist at Rutgers University who has also studied the Great Depression, said tax increases in 1937 contributed to the second slide back into recession. He said he expects the recently enacted federal cuts to cause a short-term reduction in national economic growth. “I would not say that it will have a huge driving effect on the economy,’’ he said.

White also said that for years after the Great Depression, banks were wary of making loans, much as banks today are lending cautiously, contributing to slower growth. “I would say banks are caught between a rock and a hard place,’’ White said. “On the one hand, government wants them to lend more, and on the other hand, we don’t want them to take any important risks.’’

Robert Murphy, a Boston College economics professor, said the double-dip recession of 1981 was deep, but the economy rebounded quickly.

But with unemployment stubbornly high - 9.2 percent in June - the billions in cuts to federal spending over the next decade could push the nation backward into a recession.

Yesterday’s report of a fall in consumer spending only increased the possibility, he said.

“If there’s concern among households it’s that they have too much debt,’’ Murphy said. “Families think: how is reducing the federal deficit going to help my balance sheet?’’

Megan Woolhouse can be reached at mwoolhouse@globe.com.