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'Fiscal Cliff' Fight Already Drags on US Economy

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Worries about the federal government's "fiscal cliff" are taking their toll on the economy well ahead of the year-end deadline, which analysts say is looking like it may be more damaging in the run-up than in the reality.

Businesses frequently cite uncertainty about what will happen with $600 billion in government spending cuts and expiring tax breaks scheduled to start taking effect Jan. 1 as their reason for refraining from hiring or spending on facilities and equipment. Reports make it clear that this uncertainty contributed significantly to the economic slowdown in the spring and summer as well as to a continuing slump in manufacturing.

Activity at the nation's factories -- already depressed by the recession in Europe and slowdown in China, two of the biggest U.S. export markets -- went into reverse during the summer as U.S. businesses put orders on hold.

Job growth trailed off from robust levels of more than 200,000 a month earlier this year as employers shied away from making permanent staffing decisions in a fog of political uncertainty.

"The primary catalyst for the slowdown in the economy has been dysfunctional fiscal policy," said Ward McCarthy, managing director at Jefferies & Co., noting that U.S. growth has slowed from 2 percent on average last year to 1.6 percent in the first half of this year. He expects growth to brake further to about 1 percent in the final months of the year.

"The closer the politicians take the economy to the edge of the cliff, the greater will be the associated anxiety and uncertainty that fiscal policy will generate an economic calamity, and the more damage that will be done," he said.

The decline in business investment -- a key source of strength driving the economic recovery since 2009 -- emerged dramatically last month when orders for big-ticket goods plummeted by 13 percent. Analysts said business investment in equipment likely declined during the summer quarter for the first time in the three-year recovery.

"As anxiety and uncertainty about the fiscal cliff have increased, businesses have made the prudent decision to delay investment spending decisions," Mr. McCarthy said.

Just as growth has slowed precipitously, hiring also hit a wall, with job growth falling from 225,000 a month on average in the first quarter to 145,000 in the summer quarter. "The labor market has clearly lost traction," Mr. McCarthy said.

Delaying hiring, investment

While business groups have complained loudly about the dangers of the fiscal cliff for months, many have told their members privately that Congress is likely to avert a disaster by agreeing to at least postpone the year-end deadline, giving time for the newly elected president and Congress to resolve the unsettled budget matters early next year. But those assurances have not sufficed to prevent businesses from worrying that their taxes could shoot up or payments on their contracts with the government could be suspended suddenly.

"There's no sense in hiring right now, and there's no point in investing right now," said David Cote, chief executive officer of Honeywell International Inc., a top defense and aerospace contractor. "We are waiting to see what is going to happen, and it causes everything to slow down."

Uncertainty about the outcome of the close presidential election is adding to business hesitation. Riding on the election is the fate of President Obama's health care reform and Wall Street regulatory measures, among other laws and regulations that impose major mandates and requirements on businesses.

Even for businesses that aren't inclined to wait, the hoopla surrounding the fiscal deadline -- including much-trumpeted predictions that it will throw the U.S. economy into a deep recession -- have led many to postpone plans until the outlook is clearer.

U.S. consumers, in contrast, seem less concerned about the year-end deadline and have even staged a minor spending revival in recent weeks. Surveys show that consumers are not paying attention to the deadline, although consternation about political gridlock overall registers with the rock-bottom approval ratings that voters give to Congress.

Punting the problem

But all the fretting by businesses may be for naught if, as many analysts expect, the deadline is punted into next year or is otherwise softened by a budget agreement that phases in austerity measures over a period of years. The latter is the scenario that economists say would produce the most favorable result for the economy and the budget deficit.

"The most likely scenario is that policymakers will come together after the elections and pass a continuation of existing tax policy and spending levels. This continuing resolution would essentially result in Congress and the administration kicking the can down the road until sometime early next year," said John Silvia, chief economist at Wells Fargo Securities and a former congressional staffer who is familiar with Capitol Hill's procrastinating ways.

While putting off the deadline would prolong the uncertainty and anxiety for a while longer, it would not do the kind of major damage to the economy that has been trumpeted in headlines this year, striking fear in the hearts of some businessmen, he said.

"It would place a drag on economic growth and weigh on financial markets" as businesses and investors await a longer-term solution from Congress, Mr. Silvia said. But it would avoid the recession that would occur if all the spending cuts and tax increases were allowed to take effect immediately.

Other Washington observers and prognosticators have reached the same conclusion: Congress will march right up to the fiscal deadline in a game of partisan chicken, but avert disaster at the last minute with at least a temporary delay or possibly a more far-reaching solution to the fiscal crisis. In the meantime, the economy will suffer as businesses and investors wait anxiously for a resolution.

It wouldn't be the first time that widespread dread in anticipation of a much-publicized event proved to have a more powerful effect on the economy than the event itself.

An economic catastrophe from the so-called Y2K computer bug in the months running up to the year 2000 was widely predicted but turned out to be a total dud. The down-to-the-wire fight in August 2011 over raising the federal debt ceiling also fizzled, but both had powerful effects on the economy before the deadline.

Pressure on the Hill

Setting up such pressure-ridden deadlines has become a hallowed tradition in Congress since the 1980s, when a series of do-or-die deadlines was enacted as part the era's Gramm-Rudman budget regime. As in the earlier era, the tactic has had middling success in forcing agreements between the parties, even if the periodic deadlines are unsettling to the markets, the economy and the public at large.

Despite all the bombast and rhetoric surrounding the fiscal deadline, business professionals familiar with the ways of Washington are well aware that the much-vaunted catastrophe is likely to be averted. An informal survey of clients by Morgan Stanley recently found that 60 percent expect Congress to "kick the can down the road," with only 7 percent expecting Congress to drive the economy off the cliff.

Business clients, in fact, were more concerned about the effect on the economy this year from worries about the fiscal standoff, with 60 percent saying "uncertainties in advance of the fiscal cliff outcome" already are depressing growth, said Morgan Stanley economist Vincent Reinhart. He expects Congress in the end to come up with a budget deal that only mildly depresses growth next year.

"We assume that a deal is struck before year-end that extends most features of the current fiscal system on the promise of some new mechanism to force a decision later next year," he said. "The exact features of the deal depend on who will be in the White House after Jan. 20, 2013, but the net effect is some modest fiscal restraint in 2013."

Hurting in the run-up

But the damage to the economy in anticipation of the much-ballyhooed deadline can still be substantial, according to Mr. Silvia of Wells Fargo.

"The effects on U.S. economic growth from political uncertainty were well documented during last year's debt-ceiling debate," he said. Consumer confidence took an unprecedented hit, plummeting by half in response to the political turmoil and a first-ever downgrade of the U.S. credit rating by Standard & Poor's Corp. in August.

Businesses slowed their purchasing and hiring decisions in a major way, just like they appear to be doing this year.

Said Mr. Silvia, "We believe a similar effect is possible on both consumer and business confidence in the fourth quarter of this year if policymakers wrangle over how to continue the bulk of existing policies for a prolonged period. A short-term patch would then result in a second wave of reduced business and consumer confidence as the new Congress and potentially a new administration attempt to determine a more long-term solution to the currently unsustainable fiscal situation."

Frederick Cannon, analyst at Keefe, Bruyette & Woods, said the greatest damage to the economy could occur around the Christmas holiday if, as he expects, Congress postpones action on the fiscal deadline until a lame-duck session after Thanksgiving.

"December has the highest monthly level of discretionary consumer spending in the U.S., and the contentious debate over the fiscal cliff in that month is likely to damage consumer confidence," he said. Moreover, the stock market is likely to get drawn into the maelstrom, as Congress often dallies over deadlines until it sees a major reaction in the stock market that forces it to act.

"It is likely that resolution happens as a result of the stock market declining significantly, thus investors need to prepare for a sell-off," he said.

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