Jan. 1, 2013, seemed a long way off in the Chicken Summer of 2011. That’s when Congress reached a deal that ended, or rather postponed, the debt-ceiling crisis by declaring that automatic cuts in federal spending would be triggered at the beginning of 2013, unless a bipartisan supercommittee came up with a sweeping plan for reducing the deficit. (Predictably, it didn’t.) Even last August some House Democrats worried that their party had given away too much. Emanuel Cleaver of Kansas City, Mo., called the debt deal a “sugar-coated Satan sandwich.” Steve Cohen of Tennessee was even more imaginative. “I fear it’s a Trojan horse,” he said in floor debate on Aug. 1. “And if you look inside that Trojan horse, it’s Scylla and Charybdis inside, the whirlpools and the shoals.”
Now the Trojan horse with the roiling belly is staring us in the eye. With the attention of the political class fixated on the presidential campaign, Washington is in danger of getting caught in a suffocating fiscal bind. If Congress does nothing between now and January to change the course of policy, a combination of mandatory spending reductions and expiring tax cuts will kick in—depriving the economy of oxygen and imperiling a recovery likely to remain fragile through the end of 2012. Congress could inadvertently send the U.S. economy hurtling over what Federal Reserve Chairman Ben Bernanke recently called a “massive fiscal cliff of large spending cuts and tax increases.”
The opposite risk is that Congress goes weak in the knees and postpones all the tough decisions for another day. That would saddle future generations with unsupportable debt while feeding the perception that the U.S. will never get its deficits under control. It could finally alarm the vigilantes of the bond market, driving up interest rates on America’s nearly $11 trillion of publicly held debt.
Which is worse? One is reminded of the Woody Allen joke: “One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose correctly.”
In recent months, some American policymakers have congratulated themselves for ignoring the example of their European counterparts and resisting austerity measures after the Great Recession; as a result, the U.S. economy is expanding, while much of Europe has stagnated. Now, unless the White House and Congress get serious about hammering out a credible, long-term plan for deficit reduction—one that phases in spending cuts and tax increases over a decade—Americans will wake up next New Year’s Day facing either a prolonged deficit binge or excessive austerity that could push us back into recession. And we’ll have no one but ourselves to blame.
The Bush tax cuts, conceived during his 2000 campaign when the U.S. was running budget surpluses, are a big factor in America’s long-term gap between revenue and expenses. Even bigger is the mounting cost of entitlements: Medicare, Medicaid, Social Security, veterans’ benefits, pensions, and so on. Stimulus measures to drag the U.S. out of its current slump are a comparative flyspeck because they’re temporary. The right formula is stimulus now, austerity later; accelerator now, brake pedal later.
Hitting the brakes too soon would be unwise. The automatic spending cuts, known as a “sequester” under the Budget Control Act, are only part of the austerity that’s slated to take effect on Jan. 1. That same day, the 2001 and 2003 Bush tax cuts will be over if current law stays on the books. The Obama payroll tax cut and emergency unemployment benefits are also slated to expire. Barclays Capital calculates that if all those changes occurred as scheduled, they would subtract 2.8 percentage points from the economy’s annual growth rate in the first quarter of 2013, leaving growth at just 0.2 percent—a hair’s breadth from recession.
Congress probably won’t let that happen. It’s likely to shrink the automatic spending cuts, which are supposed to add up to a little over $100 billion, split evenly between defense and the rest of the budget. Congress is also likely to extend at least part of the Bush tax cuts again. “That’s the path of least resistance. And you can almost always count on Congress to go that route,” says Michael Linden, director of tax and budget policy at the Center for American Progress, a Democratic think tank. Barclays senior economist Michael Gapen expects the more modest spending cuts would trim about 1 percentage point off GDP growth in the first quarter of 2013.
That doesn’t mean there’s nothing to worry about come Jan. 1. First, the plan that Congress devises on deadline is likely to be a political patch, not a well-thought-out agenda for efficiency, fairness, and growth. Second, judging from recent negotiating history, it’s likely to happen in a messy drama of brinkmanship that will damage business and consumer confidence, as the debt ceiling debacle did last summer. (The bond market took the brouhaha in stride, but shoppers and CEOs were rattled.) Anything that heightens uncertainty could chill economic growth, says Michael Englund, chief economist of Action Economics in Boulder, Colo.
Procrastination is part of the problem. Congress probably won’t take up the automatic spending cuts until after the November elections, giving it less than two months before the New Year for a complex lame-duck negotiation. It may come up with some kind of bridge financing that hands the problem to the new Congress that takes office in January.
Making matters worse, the fiscal 2013 budget, which is supposed to be passed by Oct. 1, may still be flapping around as all this goes on. So, as in 2011, there’s a risk of a government shutdown that would produce mass federal layoffs. And—shades of Chicken Summer—the U.S. will be bumping up against the debt ceiling again sometime between late 2012 and early 2013. With so many eggs to juggle, it’s easy to imagine at least one going splat.
The only people making a worse hash of austerity than the Americans are the Europeans, who also have a fistful of frugality scheduled for Jan. 1, 2013. That’s when the European Union’s tough new deficit-reduction treaty will go into force if ratified. It limits members to full-employment budget deficits of just half a percent of GDP (1 percent for the least indebted nations). That’s a recipe for overly stringent fiscal policy that could kill Europe’s growth.
Germanic austerity gets good press because it’s perceived as financially prudent. But when an economy is operating way below capacity—as America’s is now—government deficits may actually be the more financially prudent course. A paper delivered at the Brookings Institution on Mar. 22 by economists Larry Summers of Harvard University and Brad DeLong of the University of California, Berkeley says that a protracted slump can damage an economy’s long-term growth potential “through discouraged workers, lost skills, broken organizations, and missing investment on future productivity.” Summers and DeLong argue that government spending that stops such a destructive slump and restores healthy growth can pay for itself by generating higher future tax revenue. It’s like a lefty version of the Laffer Curve, which says tax cuts pay for themselves.
Fortunately, there is a better choice for 2013 than either extreme austerity or no austerity at all. And it’s not just splitting the difference between two ugly options, which is Congress’s usual approach. The better choice is a long-term plan that credibly shrinks deficits with a phased-in combination of spending cuts and higher tax revenues. It would look something like the bipartisan Bowles-Simpson commission plan from 2010, or the Obama administration’s own 10-year plan from its 2013 budget. The plan of Republican House Budget Chairman Paul Ryan has good points, too, although it unrealistically tries to keep federal revenues to no more than 19 percent of GDP “for the foreseeable future.” The Committee for a Responsible Federal Budget, which has its own blueprint for deficit reduction, approvingly quotes Bernanke’s advice to Congress to “figure out ways to achieve the same long-run fiscal improvement [as sequester would achieve] without having it all happen at one date,” namely Jan. 1.
Good advice, but Congress is not known for getting ahead of problems. So expect a fiscal cliffhanger as the year draws to a close. If things get too scary, Obama, or whoever succeeds him, may have to deal with yet another of Washington’s self-inflicted wounds.