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Debt debacle damage could mean double-dip

Washington's spectacular failure to manage the nation's finances has raised concerns that a gridlocked government is also powerless to revive a slowing economy.

The latest economic data raised fresh fears that recovery could soon turn back into recession. The nation's gross domestic product, the broadest measure of the economy, rose at an anemic 1.3 percent annual rate in the second quarter, the Commerce Department said Friday.

Revisions to first-quarter data were more alarming. The government now says the economy grew just 0.4 percent in the first three months of the year, not the 1.9 percent gain logged in its previous report.

"Everybody expected GDP to be weak for the second quarter," said Tim Ghriskey, chief investment officer of Solaris Asset Management. "But this is a pretty shockingly low number. The revision to the first quarter is even more shocking."

Much of the second-quarter weakness came from a sharp slowdown in consumer spending, which rose just 0.1 percent in the second quarter after rising 2.1 percent in the first three months of the year.

Consumers have had plenty of reasons to pull back this year: Job prospects are grim, wages have barely budged and a surge in gasoline prices took a big bite out of their household budgets.

Consumer sentiment continues to worsen. A widely followed index released Friday fell in July to its lowest point in more than two years. The ongoing spectacle of dysfunctional government isn't helping, according to Richard Curtin, director of the Thomson Reuters/University of Michigan consumer sentiment index.

"While consumers may not fully understand the debate about the federal debt, they do understand the meaning of the oft-repeated warnings of 'dire economic consequences,"' he said.

There were some bright spots in the economic data. Business investment growth picked up in the second quarter, as companies continued to try to expand output without hiring more workers. A lower dollar is also helping American companies that sell their products in booming overseas markets where economic growth is strong. Car sales, hit hard by supply interruptions from the earthquake in Japan, are expected to rebound in the second half of the year.

Those positive forces were offset by ongoing spending cuts by state and local governments. Now, as the federal government moves to make broad budget cuts, those headwinds will get stronger.

With just days left before the government runs out of cash to pay its bills, Congress and the White House are veering toward an economic calamity of their own making. As of Wednesday, the most recent update available, the Treasury had just $73.8 billion left in its account with the Federal Reserve. That means the U.S. government is holding less cash to fund operations than banks like Citigroup or Morgan Stanley.

If Congress fails to restore the Treasury's borrowing authority by next week, the shutdown of federal payments for everything from Social Security checks to the nation's air traffic control system would be felt within days.

Damage to the economy would be severe. Government spending represents about 10 percent of GDP. Removing that spending would produce an immediate, sharp contraction in economic growth.

Friday's GDP numbers underscored just how vulnerable the recovery is to a prolonged debt ceiling deadlock.

"There is absolutely no good news in this report," said David Semmens, U.S. economist at Standard Chartered. "One would really hope that it will focus the minds of those in Washington on resolving the debt ceiling issue as soon as possible."

Even if a deal is reached in time, it remains to be seen how much lasting impact the debt debacle will have on businesses and consumers. The damage to confidence could ease once an agreement is reached.

But there is little government can do now to revive economic growth. Another round of stimulus spending is out of the question. If anything, the inevitable spending cuts will act as a further drag on an economy that it already dangerously close to recession.

"With a fiscal consolidation on the way, it is hard to see the economy getting much stronger, said Paul Dales, a senior economist at Capital Economics.

The Fed, meanwhile, recently announced it was adopting a "wait and see" policy after pumping $60 billion of cash into the financial system while holding interest rates near zero.

Fed policy makers are forecasting a pickup in growth in the second half as the central bank waits for signs that recent policies are working. If they aren't, there isn't much more the Fed can do to get the economy moving again.

"Monetary policy is not effective," said Paul McCulley, a former portfolio manager at PIMCO, a large investment fund. "It doesn't mean that the Fed is not very competent. It simply means that the private sector is (paying down debt) and doesn't want credit at any price."