Debt ceiling: With debate on hold, where is US economy headed now?

Like a sailboat caught in the doldrums, the US economy in 2013 is looking for a puff of wind to get it moving again.

Seemingly every bit of positive economic news is offset by some that is negative:

Tax rates for most everyone who works are up, now that the payroll tax cut has expired, but then so is the housing market. Consumer confidence is down, but a leading cause for that dip has expired with the resolution, however much criticized, of the crisis over the "fiscal cliff." Job creation is uninspiring, but corporations are loaded with cash.

While the US economic ship is in calm waters for now, the most visible clouds on the horizon are angry and dark and coming from Washington, in the form of the debate over raising the federal debt ceiling. House Republicans passed a bill Tuesday suspending the debt ceiling for three months to facilitate negotiations over the federal budget, but the measure, which is also expected to pass the Senate, does not bridge the gap on spending issues and may serve only to forestall the battle.

Exactly how perilous is that D.C. drama over the debt ceiling to the nation's economic health? The nerve-racking brinkmanship on the issue in the summer of 2011 was enough to spook Wall Street and lower the US debt rating.

And if the word "recession" isn't on the lips of most economists, some trace a path in that direction if the debt-ceiling issue isn't resolved.

But more on that later. First, let's take a look at why the economy is stuck in neutral, or as John Silvia, chief economist at Wells Fargo Securities in Charlotte, N.C., terms it, why "we are entering a slow-motion situation."

How slow? Mr. Silvia estimates the gross domestic product will increase at a 1.4 percent rate in the first quarter before showing some improvement, ending the year growing at a 2.4 percent annual rate. In other words, the economy may not be much different than last year.

Here are some of the head winds and tail winds the 2013 economy is facing:

HEAD WINDS

The debt-ceiling battle

President Obama wants Congress to authorize an increase that will allow the government to pay its bills for several years. Republicans, while temporarily waiving a demand that increases in the debt ceiling be matched dollar-for-dollar with spending cuts, still hope to use the issue as leverage in negotiations over the federal budget.

How damaging could the battle be?

In mid-January, US Treasury Secretary Timothy Geithner, in a letter to Congress, said the government had, since the beginning of the year, been juggling accounts to meet its debt obligations and pay for such things as Social Security checks, veterans' benefits, and money owed to contractors.

"Even a temporary default with a brief interruption in payments that Congress subsequently restores would be terribly damaging," Mr. Geithner warned.

With the imminent threat of default removed for now, the next potential challenge to the economy could come from sequestration, the across-the-board automatic government spending cuts that were the price of the last fight over the debt ceiling. To avoid sequestration, Congress must find a way to either add revenues or reduce spending by $85 billion by March 1. Then, by March 27, Congress has to pass a continuing resolution to fund government operations.

In a Jan. 13 memo to clients, Pete Davis of Davis Capital Investment Ideas said he expects Congress will figure out a way to avoid sequestration.

"They will go to great lengths to avoid sequester; it is unlikely to go into effect," he says.

Even if sequestration were to go into effect and Congress were to fail to pass the continuing resolution, budget experts don't believe that would drive the economy into a downturn unless the congressional impasse dragged on for a long time.

But the potential for a default on the debt could be even more dangerous for the economy than the fiscal cliff, says Dan Meckstroth, chief economist for the Manufacturers Alliance for Productivity and Innovation (MAPI) in Arlington, Va.

"If we went over the fiscal cliff, we would have gone into a recession that would have lasted no more than two quarters," he explains. "But we would have come out of it, and because of the combination of tax increases and spending cuts, we would have been on a path to stability."

With even a slight prospect of a default, "the markets could react very badly," says Mr. Meckstroth. "The last thing you want is a default on the interest on your securities," he warns. "Just the possibility is a dangerous situation."

The last time Congress pushed back on raising the debt ceiling was August 2011. The Dow fell more than 620 points the day after Standard & Poor's downgraded the US credit rating amid the partisan rancor. In its downgrade, S&P said it was pessimistic the two sides could reach a broader compromise that would stabilize the US fiscal situation.

But other economists say this time the parties will find a way to avoid that harmful scenario.

"I don't believe, despite all the huffing and puffing and all that bluster, that at the end of the day Congress will let us default on the debt," says Stuart Hoffman, chief economist at PNC Financial Services Group in Pittsburgh.

No momentum from 2012

The US economy did not get its usual kick from holiday spending, in part because of the cliff debate. With some pundits proclaiming the United States would go into a recession if Congress did nothing, consumers became more cautious about pulling out their wallets.

"We're getting no momentum from holiday spending," says Silvia.

ShopperTrak, a retail research organization, estimates that holiday sales were up 2.5 percent over 2011, the slowest pace in three years.

It did not help that many portions of the Northeast were hammered by superstorm Sandy in late October or that the Midwest had a major snowstorm right before Christmas.

"We were fortunate to get that 2.5 percent increase," says Bill Martin, founder of ShopperTrak, which is based in Chicago.

Less cash in our pockets

Almost all working Americans entered the new year paying more taxes because of the expiration of the two-year cut in payroll taxes. On Jan. 1, those taxes, which normally pay for individuals' contributions to Social Security, rose from 4.2 percent of earnings to 6.2 percent.

In terms of the entire economy, it's not that much money – about $120 billion, estimates Roberton Williams, a fellow at the Tax Policy Center in Washington.

"But it is just dead weight on the economy," he says. "It takes $120 billion out of the economy that could have been spent."

Mr. Williams estimates it comes to about $900 to $1,000 per household, or $20 per week.

No one knows what actually happened to the money over the past two years, Williams says. He thinks low-income wage earners "spent it before they got it." Middle-income earners may have used some of it to pay bills. "I'm sure at the top end it was all going to the bank," he says.

The way John Canally, chief economist at LPL Financial, views the increase in the payroll tax: It absorbs a 1 to 2 percent pay raise.

"It will be almost all taken away since this tax went up," says Mr. Canally.

TAIL WINDS

A rebounding housing market

The housing market will continue to help the US economy grow as developers try to meet a rising demand for apartments and to a lesser extent new homes.

In the coming year, construction of single-family homes will rise by 20 percent and multifamily units, mostly apartments, will increase by 37 percent, estimates IHS Global Insight, a Lexington, Mass., economic consulting firm.

In fact, new housing construction will contribute 20 percent of America's GDP growth in 2013, estimates IHS.

In a normal year, most of the construction revolves around single-family homes. But developers are finding it harder to sell them because buyers are trying to rebuild their credit ratings. "They are building the homes but people aren't buying them," says economist Patrick Newport, who follows housing for IHS.

This has forced developers to shift to apartments, where rents are rising.

"There were 4 million homes lost to foreclosure [since the 2007 housing crash], and a lot of those families became renters," says Jed Kolko, chief economist at Trulia, a San Francisco-based online real estate marketplace.

In fact, spending on multifamily housing has been dynamic – rising 46 percent from November 2011 to November 2012, compared with 7.7 percent for all of construction.

At the same time, sales and prices of existing homes improved at the end of 2012. Trulia estimates prices were up 5.1 percent nationally last year. As real estate prices rise, many economists believe there is a wealth effect that helps the economy grow as Americans feel more confident about making large purchases.

Despite the improvement in housing, there are concerns about foreclosures that are still in the pipeline and how difficult it is for individuals without high credit scores to obtain mortgages.

Businesses are flush

Business is expected to spend some of its cash on new factories and the equipment to go in them.

Energy companies are adding pipelines, aerospace companies are expanding production to keep up with demand, and medical centers are gearing up for the implementation of the Affordable Care Act, when millions more Americans get health-care coverage.

An example of the spending boom: In mid-January GlobalFoundries announced it would spend $2 billion on a new research-and-development center in Saratoga County, N.Y. The R&D facility will create 1,000 jobs.

At the same time, many other companies are opening up their wallets because they deferred investment during the recession.

"They just repaired equipment or postponed replacement," says Meckstroth of MAPI. "Companies are very profitable now, and interest rates are very low, so we have prime conditions for a capital spending boom.

"The capital spending rate could be much faster if we didn't have the uncertainty with the fiscal cliff and the debt ceiling," he says.

A feel-good market?

The stock market could potentially help the economy if it continues higher.

Last year, the S&P 500 index gained 16 percent, including dividends. That added $1.375 trillion to stock portfolios.

"If someone had any exposure to stocks by being up 16 percent, it helped with their feeling of well-being and got us one step closer to full recovery," says Sam Stovall, chief equity strategist at S&P Capital IQ in New York.

Could it happen again in 2013?

Through mid-January, the S&P was up another 3 percent, a gain of $408 billion in value.

If Congress and the White House were to reach an agreement on the debt ceiling, the economy could grow closer to 3 percent instead of 2 percent, says LPL Financial's Canally.

"Then we get a 20 percent gain in the market," he says. "If they can't agree, and it lingers on, we go into a bear market and a mild recession."

PATHS TO RECESSION?

There's that 'R' word again

In a warning to Congress about the debt-ceiling issue Jan. 14, Mr. Obama said a default on debt payments could "slow down our growth" and "might tip us into recession."

Even Federal Reserve Chairman Ben Bernanke warned that a downturn is not out of the question. At the University of Michigan the same day, he described the US economy as being in a "relatively fragile recovery" and cautioned that "we want to avoid taking fiscal actions that will push the economy back into recession because that was one of the risks that the fiscal cliff posed."

So what would trigger a recession? Economist Robert Brusca of Fact and Opinion Economics offers at least two scenarios:

The US defaults on its debt

In the first and most dramatic possibility, the US government defaults on its debts and basically is declared bankrupt.

"This becomes a big financial markets issue because some firms must hold highly rated bonds or some can't hold bonds of entities in bankruptcy," says Mr. Brusca.

Under this sequence of events, as insurance companies and others race to dump bonds, yields on US Treasury securities soar. Borrowers around the world would have to pay more for loans – if they could even get them. A recession would take place quickly.

Gradual government shutdown

The second scenario, Brusca says, would be what he terms "a slow melt." The cash-strapped US government is forced to prioritize payments on the basis of what revenue it has coming in. For example, the US Treasury might make interest payments on its debt but would not pay air-traffic controllers, public parks employees, and food inspectors.

"In this game of chicken, the president shuts down the most public agencies so the public can see and feel the effects," says Brusca. "Can you imagine what happens if people can't fly?"

This would not be the first time the government has shut down over the debt ceiling. At the end of 1995, President Bill Clinton and House Speaker Newt Gingrich clashed over spending cuts and raising the debt ceiling. When Congress refused to raise the ceiling, Mr. Clinton started furloughing government workers. "The Republicans got a black eye," recalls Brusca.

The stock and bond markets took hits as well, but the economy avoided a recession. "The economy was a lot stronger then," he says.