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Shadow falls on economy

| Saturday, Feb. 26, 2011

WASHINGTON — Just when the economic recovery seemed to gain momentum, two new threats have emerged that could undermine it. One has flared in the Midwest, the other in the Mideast.

The standoff over benefits for public employees in Wisconsin, pitting Republican Gov. Scott Walker against unions and their Democratic allies, presages battles in many state capitals that could lead to hundreds of thousands of public jobs being cut nationwide. And in Washington, congressional Republicans are demanding steep, immediate budget cuts that some economic forecasters estimate would slow the pace of economic growth in 2011.

Budget cutting is taking a greater toll than analysts had expected, according to figures released Friday by the Commerce Department, which showed the economy grew at only 2.8 percent during the final three months of last year, slower than the 3.2 percent previously estimated. The disappointing result in large part reflected an unexpected 2.4 percent drop in spending by state and local governments during the fourth quarter.

Political turmoil in Libya and other Arab nations, meanwhile, has driven the price of oil up 14 percent this week and is starting to mean higher prices for Americans at the gas pump. This price spike could buffet global financial markets if the upheaval spreads.

In a dangerous twist, these two developments — higher energy costs and government austerity — could reinforce each other: If rising fuel prices lead to even slower economic growth, this could leave states with even bigger budget gaps, partly because of falling tax revenue. That, in turn, could cause state governments to cut spending more aggressively than they would otherwise.

The new risks have emerged suddenly, after several months that have seen more optimism about the economy than had been visible in years: The stock market rose 28 percent from Sept. 1 through Feb. 18; an index of expected volatility in the market fell to its lowest level since 2007; and economic forecasters and corporate CEOs alike upgraded their predictions for 2011. Just this week, a measure of consumer confidence rose to a three-year high.

"We had every reason to believe the U.S. economy will do extremely well this year," said Bernard Baumohl, chief global economist for the Economic Outlook Group. "Now we have to go back to the drawing boards."

In recent weeks, the consensus of economists had been that the economy would grow 3.5 percent to 4 percent in 2011. That would represent an improvement on the 3.2 percent growth rate that the Commerce Department initially estimated for the last quarter of 2010. Instead, the figure released yesterday is much less encouraging, 0.4 percentage point lower.

And that was before the latest spike in oil prices. According to the analysis of leading forecaster, Macroeconomic Advisers, every $10 increase in the price of a barrel of oil — about the amount of the increase so far — will reduce U.S. economic growth by a quarter percentage point.

Taken together with deep cuts in government spending, there's a distinct possibility that the economic growth will fall short of the pace needed to reduce unemployment from its stubbornly high level. Economists say the economy must expand at a rate of about 2.5 percent to 3 percent to keep up with population growth and greater worker productivity — much less add jobs.

Few forecasters are predicting that the run-up in fuel prices and potentially dramatic budget cuts will tip the economy back into recession.

But that could change if the Middle East turmoil disrupts oil production in more countries and energy prices rise sharply, sparking a new round of financial panic. The vulnerability of the global financial system was highlighted last spring, when the debt crisis in Europe sent stock markets falling around the world and set back the U.S. economy.

"This is definitely a risk that we weren't thinking about too much two months ago but we're thinking a lot about now," said Joel Prakken, chairman of Macroeconomic Advisers.

The showdown in Wisconsin over benefits and bargaining rights for public employees is one particularly intense skirmish in a broader war over the size of state work forces. State and local governments have cut 400,000 workers since 2008.

"States have already done significant cutting," said Scott Pattison, executive director of the National Association of State Budget Officers. "Federal stimulus money is drying up. They've harvested all the low-hanging fruit. Now, state leaders are pretty much running out of options."

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