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U.S. economic recovery threatened by events in Midwest, Middle East

Feb. 25 (Bloomberg) -- The U.S. economy grew at a 2.8 percent annual rate in the fourth quarter, slower than previously calculated and less than forecast as state and local governments made deeper cuts in spending. The revised increase in gross domestic product compares with a 3.2 percent estimate issued last month and a 2.6 percent gain in the third quarter, figures from the Commerce Department showed today in Washington. Bloomberg's Betty Liu reports. (Source: Bloomberg)

The showdown in Wisconsin over benefits and bargaining rights for public employees is one particularly intense skirmish in a broader fight over the size of state workforces. 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."

The Center on Budget and Policy Priorities, a liberal-leaning research group, has calculated that states face a collective $125 billion budget shortfall for next year, which would translate into the loss of 850,000 jobs if that gap were to be closed simply by shedding employees. (States are more likely to close the gap with a mix of trimming workforces, cutting other expenses, and raising taxes and fees).

The private sector has been growing fast enough to offset those declines. During the past year, for example, state and local governments have shed 237,000 jobs while private employers added 1.2 million jobs. Moreover, forecasters have already taken into account substantial further cuts by those governments in their projections.

Still, analysts were caught off-guard by the results from the Commerce Department. Previously, it had estimated that spending by state and local governments was down 0.9 percent in the fourth quarter. The revised figure shows that the drop was nearly three times as large. By contrast, state and local spending from July through September had increased 0.7 percent.

If cuts this year end up steeper than currently forecast - because a poor economy leaves states with bigger budget gaps or because fiscal hawks at the state level win the upper hand - that would further weaken the recovery.

The dispute in Washington over federal government spending has perhaps even more potential to alter the course of the economy this year. Economists at Goldman Sachs estimate that the $60 billion package of spending cuts that House Republicans passed last week, if able to overcome stiff opposition from Senate Democrats and President Obama, will reduce the pace of economic growth by 1.5 percentage points in the second quarter of this year and two percentage points in the third quarter.

If the federal spending cuts are more modest - say, $25 billion - they will still reduce second-quarter growth by up to one percentage point, Goldman found.

"We see federal spending cuts as the most important near-term risk," economist Alec Phillips wrote in the report.

A potential government shutdown, which could happen as early as Friday if the two parties cannot reach agreement on keeping the government funded, would also sap economic activity. That impact is likely to be transitory, however, with any slowdown made up for later when the government is running again.

"A one-week shutdown in March could knock a couple of tenths of a percent off of GDP growth in the first quarter, but it would add about that much back in the second quarter," said Prakken, of Macroeconomic Advisers.

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