GROWTH GAP TRIGGERS DEFICIT DISORDER / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

AUGUST 2, 2011, 4:12 P.M. ET.

Growth Gap Triggers Deficit Disorder .
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By DAVID REILLY


So much for deficit reduction.
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For all the angst over the debt-ceiling deal, the projected $1 trillion in initial spending cuts may have little to no impact on the deficit. Why? Because the numbers rely on economic-growth projections that now look unachievable.


And if the growth disappointment becomes more pronounced, the deficit will only grow larger.


The Congressional Budget Office currently projects real gross domestic product will rise 3.1% in 2011 and 2.8% in 2012. Those assumptions already look heroic. In the first half of 2011, real GDP grew at an annualized rate of just 0.8%. That means the economy would have to leap ahead by over 5% for the rest of the year to meet a 3% target. That doesn't look likely to happen.


Rather, estimates have begun to fall. Bank of America Merrill Lynch, for example, last week cut its 2011 GDP growth forecast to 1.7% from 2.3% and 2012 to 2.3% from 2.9%. Meanwhile, the Office of Management and Budget has estimated that growth one percentage point lower than forecast in 2011 could lead to a $750 billion increase in cumulative deficits over 10 years.


Given the first-half growth falloff, the damage may already have been done. In a note earlier this week, Ajay Rajadhyaksha, head of U.S. fixed-income strategy at Barclays Capital, estimated the cumulative deficit could actually be $1.2 trillion higher than projected based on the investment bank's own more downbeat estimates for 2011 and 2012 growth. That would wipe out the purported savings from spending cuts in the CBO's calculations, while government debt as a percentage of GDP would likely come in closer to 90% than the 82% envisaged by the debt-ceiling deal, Barclays noted.


And that is the case even if the current falloff in growth marks an economic soft patch rather than a longer-lasting slowdown. This remains the subject of much debate on Wall Street.


Should the economic stumble prove to be an enduring slowdown, even a second, larger round of cuts called for by the debt-ceiling agreement may have less impact on the deficit than expected.


Proponents of the soft-patch theory argue that growth has been dulled by knock-on effects of Japan's natural disaster; high gasoline prices; uncertainty bred by Europe's sovereign-debt crisis; and fears related to the U.S. debt-ceiling debate. As the impact of these fades, the thinking goes, the economy should grow at a far quicker pace in the second half.


Yet this outlook doesn't address structural challenges likely to keep the economy in a lower-gear for some time. These include consumers who continue to deleverage, banks that are still adjusting to a new financial landscape, and a moribund housing market.


Until there is more progress on these fronts, growth is likely to remain challenged. And that, more than anything, will keep fears alive that the U.S. risks losing its top-notch credit rating.
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