As Greece moves to approve austerity measures, and Spanish and Italian interest rates recede, Europe has become less of a risk to the U.S. economy. But approval of Greece's plan still rests with eurozone parliaments, and a final decision isn't expected until March, when Greece faces a key debt payment. With rampant riots and so many angry voters in Greece, the international community is anxious to see if elections in April bring a new government that will continue the austerity programs. The risk of a Greek default appears to have dissipated for now, but potential roadblocks remain.
So what are the risks to the U.S. if Europe is now less of a threat? It's not just a question of austerity and politics in Greece -- the very same issues exist right here at home. The Obama administration's proposed 2013 budget was unveiled this morning and it includes a mix of tax hikes and spending cuts. The budget warrants a discussion of its own, so I will cover that in more detail in another column. What I want to focus on are key aspects that affect the U.S. consumer, namely, the temporary payroll tax cut, and the potential expiration of extended unemployment benefits.
Let's talk a bit about what's at stake for U.S. consumers, beginning with the underpinnings of real job growth, as I discussed in this column. While we obviously want to see if job growth will continue, the trend over the past few months has been good. Hopefully, consumers will become more optimistic.
That hasn't happened yet, as I discussed in this column on consumer sentiment. Consumers are concerned because their incomes are not growing; in fact, they expect their real wages (after inflation) to fall. Because consumer spending has a correlation to income and inflation expectations, as well as net worth, we need to be mindful about how the debate in Washington might affect consumers' attitudes towards spending between now and approval of the budget. It is understood that eliminating the tax cut would have a direct effect on spending because it will reduce consumers' after-tax disposable incomes.
With gridlock in Washington threatening to stall passage of the Obama administration's budget -- and may require the elimination of key components, including the payroll tax cut -- it is not at a certainty that the payroll tax cut will be extended. A heated debate that highlights a government incapable of governing can damage confidence and weaken spending, even if the payroll cuts are extended.
And if they are eliminated? According to research firm IHS Global Insight, U.S. economic output would grow by 2.1% in 2012, assuming the temporary payroll tax cut is extended until year's end. IHS economist Gregory Daco said that the annual growth rate would fall by 0.3 percentage points to 1.8% if the tax cuts expired at the end of this month. And if the extension of unemployment benefits expires for more than 3 million of long-term unemployed, Daco estimates the combined effect of both of these policies not being renewed for the remainder of the year would bring GDP growth down even lower, to 1.6%.
If our exports suffer more than forecast to Europe, which still faces recession, as well as to Asia (Japan reported that its economy contracted by a weaker-than-forecast 2.3% in the fourth quarter), our growth may face an additional drag. It might not be enough to derail the recovery, but it could impede employment growth, which would feed back into consumer confidence.
Since the annual growth of the labor force is about 1%, and productivity gains from existing workers are around 1.5% to 2% annually, the economy needs to grow by 2.5% to 3% just to keep unemployment from rising. That's a dilemma for U.S. policymakers, right along the lines of what we see in European economies: Reducing the budget deficit will likely reduce economic growth and may keep unemployment elevated. How Washington proceeds with its budgetary process can present a risk for the economy, which still depends in part on the health of our trading partners.
One thing to remember about risk is that it is often an unknown, and it's difficult to predict the outcome when variables are known. What happens if Israel or the U.S attempt to halt Iran's production of nuclear weapons? Is the U.S. dragged further into other Middle East conflicts, such as Syria? Other factors are impossible to forecast, like earthquakes -- just look at Japan. Any of these scenarios present risk. Absent any adverse outcomes, I am constructive on the prospects for continued, moderate U.S. growth.