Will the US tip back into recession?

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A trader works on the floor of the New York Stock Exchange on November 21, 2011 in New York City. Following news that U.S. political leaders failed to reach an agreement on budget cuts over the weekend, the Dow Jones Industrial Average fell 221 points in morning trading.

Article Highlights

  • The US economy enters 2012 lacking momentum and having to cope with the fading of earlier fiscal and monetary policy stimuli.

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  • The US appears to have run out of fiscal and monetary policy space to counter any renewed economic downturn

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There are many reasons to fear that 2012 will be a highly challenging year for the US economy. This is not only because the economic recovery will face considerable headwinds and could be hit by a European financial shock, but also because the US appears to have run out of fiscal and monetary policy space to counter any renewed economic downturn with an additional stimulus.

Despite the depth of the Great Recession of 2008-09, and despite the unprecedented amount of fiscal and monetary policy stimulus, the US economic recovery has been the weakest since the second world war. In 2011, the US economy grew by little more than an anaemic 1.25 per cent, while unemployment remains stubbornly stuck at over 9 per cent of the labour force. As Professors Rogoff and Reinhart keep reminding us, this poor economic performance is what one should have expected in the aftermath of the bursting of a massive US housing and credit market bubble.

The US economy enters 2012 lacking momentum and having to cope with the fading of earlier fiscal and monetary policy stimuli. In addition, it faces the prospect of headwinds in the form of a likely further 10 per cent decline in house prices, continued deleveraging in consumer balance sheets and a reduction in spending at the state and local government levels.

The US economy also confronts the prospect of a European economic shock during 2012, as it is all too likely that the eurozone debt crisis will intensify and exacerbate the strains already evident in the European banking system. Europe is the major US trade partner while the US financial system has more than $2,000bn in exposure to the European banking system.

In the run-up to the 2012 presidential elections, one can also not dismiss the downside risk of a worsening in US-China trade relations.

The US Senate has already passed a bill that contemplates countervailing tariffs on Chinese imports to offset China’s alleged competitive edge from a manipulated currency. Such a bill, if it were enacted, would almost certainly provoke Chinese trade retaliation, but it could gain support were there to be little improvement in the US labour market situation. The poor US economic outlook will almost certainly dominate the November 2012 US presidential and congressional election campaigns. This could in itself  create a further bout of policy uncertainty at the very time that the US economy can least afford it.

Desmond Lachman is a resident fellow at AEI

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