The extra fiscal stimulus in the form of tax cuts approved in December could produce a 4 percent growth rate for the U.S. economy in the first half of 2011, but there are lingering risks that could lead to a cold shower in 2012, according to the American Enterprise Institute (AEI).

An AEI research paper written by John H. Makin outlines four major risks to the U.S. economy in 2011.

1. Hostility in the new Congress to additional fiscal stimulus
2. Higher energy costs, which could offset the boost from the payroll tax cut
3. A housing sector under heavy stress
4. Fiscal drag from state and local governments as the federal stimulus wears off

The following are excerpts from the report:


-- US economic growth looks promising in the first half of 2011, following the tax cuts in late 2010.
-- With inflation accelerating in China and the sovereign-debt crisis continuing in Europe, the best hope for sustainable global growth is more US consumption.
-- Stimulus measures may boost the economy enough to provide liftoff, but if they fail to produce lasting growth, 2012 could be painful.


The stimulus package will probably produce about a 3.4 percent growth rate in 2011, with a 4 percent annual growth rate possible in the first half and a 2.8 percent rate in the second half. These are estimates, of course, but the front-loading of the tax relief, especially the reduced payroll taxes, will give a nice boost to growth early in 2011.

Sharply increased US stimulus, the tax-relief package, and QE2 have boosted consensus growth forecasts for 2011 to well over 3 percent. Simultaneously, stronger net exports, defense spending, and consumption have pushed fourth-quarter 2010 growth forecasts up close to 4 percent. This represents a sharp turnaround from the gloom that accompanied the December 3 payroll report, which showed a rise in the unemployment rate from 9.6 percent to 9.8 percent, while meager payroll growth of 39,000 jobs--mostly temporary ones--was far below consensus forecasts.

The tax relief is important because it reduced what was about to become fiscal drag of between 1 and 1.5 percentage points of gross domestic product (GDP) starting during the fourth quarter of 2010 and continuing into 2011. While some fiscal drag persists, the tax-relief legislation has reduced it to about 0.85 percentage points of GDP for 2011.


The new Congress will be far less friendly to additional stimulus plans and may even implement fiscal consolidation. Simultaneously, the Fed will be on hold in view of increased scrutiny from a hostile House Financial Services Committee.
If the monetary-fiscal stimulus combination does not work--that is, if US growth is fading again in the second half of 2011--the US economy will face a very unpleasant 2012.

The Fed is under far too much unfavorable scrutiny to attempt another expansion of quantitative easing. Even the full implementation of its QE2 stimulus measures by the middle of 2011 is in question. Beyond that, the new Congress--especially House Republicans, as well as twenty-one Democratic and two Independent senators facing 2012 reelection campaigns and currently sensing a strong national desire for fiscal retrenchment--has already signaled that last month's tax-relief package was the end of the road for US fiscal stimulus in the near future.

Indeed, spending cuts are highly probable for the 2012 fiscal year that starts on October 1, 2011. So if 2011 does not see sustainable US liftoff, then 2012 could be a painful year in which the US economy is left to adjust on its own without the aid of macrostimulus.


Higher energy costs tied to a sharp rise in the price of oil could be a drag on disposable income. If current energy prices persist, they will constitute an estimated tax of about $60 billion on US households and firms during 2011, enough to erase a little more than half of the boost from the payroll tax cut.


The housing sector remains under heavy stress with substantial excess capacity from inventory overhang that will continue to depress home prices and household wealth. Higher mortgage interest rates tied to the rise in Treasury yields that has occurred simultaneously with higher growth prospects are also reducing housing affordability and increasing the chance of another downturn in the housing market. Another drop in real estate values would further impede credit flows from the banking sector while reducing the wealth in US households.


Since its November lows, which occurred in the aftermath of sharp global criticism of the Fed's QE2 stance, the dollar has strengthened by about 4 percent on a trade-weighted basis against a basket of foreign currencies. A combination of strong US growth during the first half of 2011 coupled with doubts about the future of the European Monetary Union will probably further strengthen the dollar. This is good news from the standpoint of US purchasing power over global goods, but it presents a challenge to US traded-goods companies attempting to increase net exports in a competitive global economy.


In Europe, the other major economic zone, the sovereign-debt crisis in southern Europe has re-intensified over the past several months. Ireland's solvency problems have been added to those of Greece. Simultaneously, the cost of insuring against default on Portuguese government debt rose to a year-end high of nearly four hundred basis points over the virtually zero cost of insuring against default on German government debt. Portugal's problems have bled into Spain since Spanish banks are heavy lenders to Portuguese borrowers in the public and private sectors. The European Central Bank and European Union have prescribed fiscal consolidation, higher taxes, and lower spending--in sum, the reverse of America's path--on behalf of the German government as the remedy for southern Europe's beleaguered sovereign bonds.

Of course, too much stringency, like too much dieting, is counterproductive. It means that painful efforts--in this case, spending cuts and tax increases--to cut budget deficits may actually increase them because such measures can sharply reduce growth, leading to a revenue collapse.