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As Over the Cliff We Go…

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Over the Cliff We Go by J. Bradford DeLong - Project Syndicate: BERKELEY – Unless something unexpected happens, the United States’ many legislated reductions in taxes over the past 12 years – all of which have been explicitly temporary – will expire simultaneously at the start of 2013. American tax rates will revert overnight to their Clinton-era levels.

Some of these reductions were implemented to fight what was seen four years ago as a temporary downturn. Although their supporters wanted to make them permanent, claiming that they were temporary allowed for the circumvention of procedural requirements in the legislative process that Democrats had created in a vain effort to guarantee fiscal sanity.

The immediate increase in tax rates is only part of the story. At the same time, automatic reductions in the defense budget and “discretionary” domestic spending – agreed to by both Democrats and Republicans in the summer of 2011 – will take effect.

Couple these tax increases and spending cuts with the provisions of “Obamacare,” the US health-care reform championed by President Barack Obama, and, as of January 1, 2013, America’s  long-run structural budget deficit disappears. The restored tax rates will, for the foreseeable future, be sufficient to support the US defense establishment, the growing US social-insurance system, and a moderate – albeit inadequate and suboptimal – amount of other “discretionary” federal spending. The US national debt/GDP ratio will be on track to fall from its current level of 75% to 50% by 2035. Moreover, the US will begin running primary budget surpluses – the fiscal balance minus interest payments on existing debt – by 2015.

So why isn’t the prospect of going over the fiscal cliff greeted with enthusiasm? Yes, there will be big spending cuts – which will hit defense contractors, doctors with Medicare patients, and all who benefit from or rely on government discretionary spending – and substantial tax increases. But, to balance the budget in the long run, either taxes have to go up or spending has to go down relative to some baseline, or both.

There are two reasons why deficit hawks are not declaring victory. First, many who call themselves deficit hawks are really spending hawks: they believe that US social insurance is too generous to the unemployed, the disabled, the elderly, and the sick, and that by far the best policy is to cut back on such programs rather than raise taxes to pay for them. But, they fear that calling for spending cuts will be unpopular, unlike, they hope, demands to balance the budget. For them, the problem with the fiscal cliff is that it does not cut spending enough and raises taxes too much.

Second, and more important, the process is not well-described by the term “fiscal cliff.” It is, rather, an austerity bomb that hits an economy in which unemployment remains high, the employment-to-population ratio remains horrifyingly low, and there are only feeble signs that the large gap between current and potential output is closing.

The past two months’ run-up to the austerity bomb’s detonation has already reduced projected real GDP growth in 2013 from 3% to 2.5%, and has raised likely end-2013 unemployment from 7.5% to 7.7%. Each day from January 1 to June 30 that the damage continues will have a roughly linear impact on economic performance in 2013, reducing the likely full-year real GDP growth rate by 0.0084% – and only if a deal is ultimately reached that would have caused no economic harm in 2013 had it been reached on November 10, 2012. If no deal is reached by June 30, America’s likely 2013 real GDP growth rate will be -0.5%, with the likely unemployment rate returning to 8.9%.

Spending cuts and tax increases that in the long run restore fiscal sanity and balance are good. Having them all hit a weak, still-depressed economy simultaneously is not good. Thus, US officials face four tasks.

  1. Republicans and Democrats must negotiate a bipartisan agreement to stretch out the spending cuts and tax increases that take effect on January 1, 2013. That way, they will affect the economy gradually over five years, rather than all at once.

  2. The Federal Reserve should expand its quantitative easing and forward guidance programs. Consumers will be spending less in 2013, owing to higher taxes, as will government, which means that someone has to be spending more. Housing construction and exports are the obvious candidates, and both can be boosted somewhat by more aggressive balance-sheet operations by the Fed, together with promises of continued low nominal interest rates and higher inflation in the medium term.

  3. The large government-sponsored mortgage enterprises, Fannie Mae and Freddie Mac, should be used as macroeconomic-policy tools to restore housing construction to its long-term trend level. This should have been done five years ago, but better late than never.

  4. And also, five years too late, the US Treasury secretary should announce that while the string-dollar doctrine was appropriate (and in America’s interest) during the dot-com boom, the country needs a weak dollar in the aftermath of the austerity bomb’s detonation.

Reaching the wrong agreement to defuse the austerity bomb, or cushion the economy from its impact, would merely recreate America’s long-run structural budget deficit – a very bad outcome. Failure to take all four steps outlined above all but guarantees renewed recession in America, even if a good agreement is reached on stretching out the tax hikes and spending cuts.

And if no agreement is reached on that, undertaking the last three steps would at least reduce somewhat the subsequent damage.