Will Strong Growth Resume in 2013? Don't Bet On It

Last week, Washington was buzzing with talk of tax cut extensions and additional stimulus. With unemployment still hovering around double-digits, policymakers think it's wise to delay deficit reduction until after the U.S. economy recovers. So additional measures will be put in place to push down the unemployment rate and encourage business activity. But what happens once the economy finally stabilizes closer to full employment? Prepare for a period of very slow growth.

Think about how the best possible future will unfold. Assuming Congress gets its act together, for the next two years tax rates will remain relatively low and employment will slowly rise. If all goes to plan, by the end of 2012, we'll see unemployment a little below 8%. At that time, with the labor market steadily, though slowly, improving, Washington will turn to deficit reduction and the Federal Reserve will no longer feel the need to engage in expansionary monetary policy. Let's consider both effects.

Fiscal Tightening

In 2013, we can expect a few things to happen on the fiscal side. First, Washington is going to finally have to get serious about the deficit. Very high unemployment will allow Congress to postpone serious debt reduction policies until then. But when the recovery is clearly underway and unemployment begins steadily declining, the government will have to stop spending money so wildly.

Higher Taxes

The most obvious first step in 2012 will be to raise taxes. It is likely that we'll see some tax reform that will include higher rates across-the-board. Taxing the rich alone can't close the deficit entirely, so the middle class will also have to pay more.

Less Spending = Entitlement Reform

In addition to higher taxes, spending will also have to be more controlled. To curb government spending significantly, you must reform entitlements. Social Security and Medicare could become less generous, for example. Whatever amount of money the government saves on entitlements will translate to fewer dollars spent by Americans.

Both of these changes will ultimately mean the same thing: Americans will have less money to spend and save. Consequently, firms' revenue and investment with both decline. This doesn't mean that a new recession will hit, but it does mean that strong growth will be more difficult, with less money being spent and invested.

Monetary Tightening

Government taxing and spending is only one way in which Washington affects the economy, however. The Fed has also taken extraordinarily aggressive measures to keep the economy stable and growing over the past few years. The federal funds rate has been near zero since late 2008. The Fed has also engaged in multiple quantitative easing efforts to keep longer-term interest rates low as well.

But in 2013, or possibly even a little earlier, when the economy appears to be on more solid footing, the central bank will have to tighten monetary policy to avoid runaway inflation. To do so, it will have to sell most of the assets on its bloated balance sheet and raise interest rates.

Once the Fed begins allowing interest rates to rise, this will further dampen economic activity. Businesses will face more expensive loans if they hope to expand. Americans will be discouraged to spend as saving account interest rates rise. Home buying will also face a headwind as mortgage interest rates increase to levels not seen in years.

Again, this won't necessarily cause a recession, but it will make a high rate of GDP growth harder to achieve.

Irrational Expectations?

Yet, the wisest economists in the land don't appear to see this inevitable result. Look at the most recent GDP growth estimates from the Federal Reserve's Open Market Committee:

fed gdp 2010-11 v2.png

You can see that their 2013 estimates range from 3% to 5% and are concentrated between 3.5% and 4.6%. How could this happen with higher taxes, less money from entitlements hitting the economy, and a rising interest rate environment? The presence of aggressive fiscal and monetary tightening measures will make strong growth very difficult to achieve.

Yet there have been times throughout history when interest rates and taxes were relatively high and the U.S. managed to grow rapidly. One prime example is the late 1990s. Yet that was a time that included the rise of an important new technology -- the Internet -- that provided much higher growth than was normal. So if another unexpected new advance hits around 2013, then it could also propel the U.S. to high growth. But assuming the economy hums along at its usual pace, keeping growth as high won't be easy.

In the decade or so following 2013, you'll likely get more of the same. It will take at least a decade, not just a few years, to reduce the deficit and broader national debt by a meaningful amount. And the Fed's balance sheet has grown so large that it will have to sell assets for years to shrink it down to a manageable size, while keeping interest rates high for an extended period to prevent inflation. So the longer-run estimate above of between 2.4% and 3.0% is a little more reasonable, but still might be optimistic. It's pretty hard to see how the U.S. can really hope to achieve growth much above 2% in the sort of economic climate that will be necessary after 2012.