US state and individual spending cuts dash recovery

While much attention has been focused on increased spending at the federal level in the United States, whether bank bailouts or stimulus packages, the spending cuts by local governments and individuals have acted in the reverse direction. This is going to make the recession longer and deeper than optimists believe.

Just look at the fiscal nightmare now confronting Californian Governor Arnold Schwarzenegger, with a pay cut so far of 14 per cent for 235,000 state employees. Arizona, Indiana, Ohio, Connecticut and Missisippi are among other states facing major budget deficits and spending cuts because the recession is slashing tax receipts.

Consumer cutbacks

At the same time US consumers are saving and not spending, with the annual savings rate now at a 60-year high of $769 billion. That is money coming out of the US economy, and if the figure looks familiar that is because it is almost the same size as President Obama’s stimulus package.

The Federal Government has been attempting to save the US economy from an even deeper slump by its interest rate cuts, bank bailouts and stimulus measures. But this is being at least partially undone by private savings and spending cuts at the state level.

However, there has always been considerable doubt among economists about a country’s ability to spend its way back to prosperity, especially in a nation whose economic problems arise largely from overspending and debt, particularly housing mortgages.

When households have overspent they have two solutions: sell the house or cut spending to service and repay loans. Remortgaging and indulging in another round of spending would not make this situation better. It would create a worse position with bigger debts and a longer time horizon for repayment.

The equivalent for a nation is a long recession, a period of below average consumption to make good some of the acummilated deficit. But the danger then is that this downturn in consumption can compound into a deflationary spiral and depression.

Pain to come

Economists are only too aware of this problem, and that appears to have made some investors overconfident about a quick solution. The reality is more subtle, and while some of the very worst of the downturn can be avoided that is a considerable difference to avoiding it all.

It is this unwinding of negative personal and state balance sheets that is going to prolong this recession, which may be less than half-way done. And while that is happening there is the threat of a further banking crisis as bad loans continue to be unwound both for personal and corporate credits.

And a final sting-in-the-tail is likely to be a bond market crash as the public sector will eventually only be able to borrow to meet its commitments by paying very much higher interest rates. The recession is therefore far from over.