Is the U.S. Economic Expansion in Jeopardy?

The advanced economies of the world all turned down in the Great Recession and have experienced only weak recoveries since. Now much of Europe is stumbling, with the weakest economies back in recession and others on the verge. One reason is austerity in fiscal policies. In the UK, the Chancellor of the Exchequer has imposed a more deflationary budget despite marking down his forecast for the economy. Within the eurozone, fiscal austerity is keeping high deficit countries in recession and adding to the recession risk in others. Even Germany is now forecasting virtual stagnation in coming quarters.

The U.S. interacts with Europe through many channels and its markets and economic cycles are usually highly correlated. With Europe in trouble and the fiscal cliff threatening fiscal austerity, how likely is a new U.S. recession in 2013?

U.S. in Expansion Mode

Unlike the situation in most European economies, the U.S.  recovery, which has been disappointingly weak, shows signs of getting stronger. Employment gains have quickened in the second half of the year. Consumer attitudes are improving. And some important cyclical sectors of the economy have been looking up.

Housing starts declined by 70 percent from their peak levels and remained depressed for years. Helped by the Federal Reserve’s easing policy, homebuilding finally started to recover during 2012. Mortgage rates are low and house prices have risen modestly in most areas of the country. So conditions are right for extended strong construction gains from here.

Automobile sales, another highly cyclical sector, will also contribute to faster growth. In the years before the downturn, annual sales of cars and light trucks averaged around 16 million units. In 2009 unit sales fell to around 9 million, and they will average near 14 million this year. But the potential sales rate is substantially higher. The average age of the car fleet rose during the past four years so replacement demand will be exceptionally high for an extended period.

Don’t Fear the Cliff

So we confront the dangers of the fiscal cliff with an economy that appears distinctly healthier than it was a year ago. If fiscal policy was not changing, this underlying strength would point to faster GDP growth in 2013. If we got a worst case outcome from the budget talks, with all the deflationary measures now scheduled having full effect, it would bring on a new recession. But that is not going to happen. And if we get a modest fiscal tightening out of this crisis, it would not disrupt the expansion.

And with a very high probability, that is what we will get.

Unfortunately, it is not likely that a rational process to address long run budget problems will emerge. That will require some difficult choices that include how best to contain the rise in future medical costs. The present crisis is not the environment for such serious matters. But if the imminent debt ceiling confrontation were also resolved now, it might signal a willingness to address the long run problems early in the next Congress.