The Fiscal Cliff Deal and the Damage Done
Ordinarily we call a deal in which neither side gets what it wants a victory for democracy. Shared sacrifice produces moderation and probity. But any process in which the Speaker of the House tells the Senate Majority Leader “Go f--- yourself,” as John Boehner instructed Harry Reid at the height of fiscal cliff madness, deserves just a bit of examination.
The Jan. 1 deal, which Wall Street cheered, moderates tax increases and spending cuts that would have amounted to more than $600 billion in 2013. It’s worth noting, though, that the fiscal cliff was the mooncalf monster-child of Congress itself. The automatic spending cuts (“sequester”) were invented by an act of Congress a mere 17 months ago after the 2011 debt ceiling showdown. To praise this new deal as an accomplishment is to praise an arsonist for extinguishing his own fire.
Congress voted to permanently preserve the Bush tax cuts for roughly 99 percent of taxpaying households, but the rate increase for the 1 Percent has infuriated antitax purists, who vow to exact more spending cuts in a couple of months, when the U.S. faces the triple threat of a debt ceiling, postponed automatic spending cuts, and expiration of the law that keeps the government funded. The arsonists now have a new box of matches.
Why have Americans been sentenced to this years-long cycle of pettiness, delay, and zero-sum gamesmanship? You could argue it’s a crisis of leadership—that our elected representatives are examples of our worst, most partisan selves. That seems unlikely. Rather, the budget conflict, at its essence, is a clash over something that rarely lends itself to compromise: morality. Budgetary puritans believe, ferociously, that too much government spending is not just inefficient, but self-indulgent. They view the world’s largest economy as an indebted family that needs to get back to basics. “The federal government needs to tighten its belt just like every hardworking American family has had to do during our economic recovery,” Representative Kurt Schrader, a fiscally conservative Blue Dog Democrat from Oregon, said last year.
The economy-as-family metaphor is familiar, emotionally intuitive—and incorrect. It’s a fallacy of composition: What’s true for the part is not necessarily true for the whole. While a single family can get its finances back on track by spending less than it earns, it’s impossible for everyone to do that simultaneously. When the plumber skips a haircut, the barber can’t afford to have his drains cleaned.
British economist John Maynard Keynes explained the futility of trying to shrink an economy into prosperity via thriftiness in his A Treatise on Money in 1930: “Mere abstinence is not enough by itself to build cities or drain fens,” Keynes wrote. “If Enterprise is afoot, wealth accumulates whatever may be happening to Thrift; and if Enterprise is asleep, wealth decays whatever Thrift may be doing. Thus, Thrift may be the handmaiden of Enterprise. But equally she may not. And, perhaps, even usually she is not.”
So let’s try a different metaphor. The economy is not a family but an engine that’s stuck in low gear. It doesn’t need a disciplinarian; it needs a mechanic.
The primary goal of government should be to get the economy running at full throttle once again. That will restore jobs and wealth and increase tax revenue, which narrows budget deficits. Mark Blyth, a Brown University political scientist with a forthcoming book called Austerity: The History of a Dangerous Idea, says: “Democrats should have said to Republicans, ‘You’re the guys who created the debt. We’ll deal with the debt when we return to growth. Get lost.’”
That’s a slightly kinder way of rephrasing Boehner’s instructions to Reid, but there’s economic wisdom beneath the brushoff. Budgetary puritans may be sincere, but they’re confusing a short-term problem with a long-term one. In the 2020s and beyond, the country risks an explosion of debt caused by the aging of the population and rising health-care costs. That must be dealt with. But in the present, with the economy still operating 6 percent below its potential (chart), it emphatically does not need a big dose of deficit reduction.
If Congress were stacked with 535 centrist macroeconomists, it would have voted to supply more stimulus to the economy immediately while also setting up a mechanism for reducing deficits over the long term. “If stimulus is part of a credible long-term deal, that’s the best of all possible worlds,” says Chris Varvares, co-founder of St. Louis-based Macroeconomic Advisers.
The deal that Congress produced does roughly the opposite. It subtracts stimulus in the short term while worsening the long-term budget picture. George W. Bush’s tax cuts of 2001 and 2003 took a huge bite out of the government’s revenue, but at least they had expiration dates. In contrast, the tax cuts in the budget deal that passed in the Senate are permanent. Theoretically, they can be ended by a future Congress. Politically, though, it’s much harder to raise taxes than to allow cuts to expire.
If it weren’t obvious enough, neither party has a monopoly on fiscal intelligence. At Democrats’ insistence, Congress did nothing to “bend the curve” on spending on Medicare, Medicaid, and Social Security. Entitlement spending—mostly on the health-care side—could derail the U.S. economy in coming decades if left unaddressed. A small change in the trajectory of entitlement spending and taxation would have furthered the goal of “gas now, brakes later”—having very little impact in the next few years but becoming increasingly valuable in coming decades, when the deficits begin to explode. Alan Simpson and Erskine Bowles, who co-chaired President Obama’s deficit-reduction commission, lamented in a statement that “the deal approved yesterday is truly a missed opportunity to do something big to reduce our long-term fiscal problems.”
What complicates efforts to get government policy right is that the world has changed in a way that most politicians, and even many economists, fail to grasp. In ordinary times, steering the economy is best left to the monetary policy of the Federal Reserve. The Fed, with its ability to raise and lower short-term interest rates instantly, can act faster and with more finesse than any legislative body. But Federal Reserve Chairman Ben Bernanke has taken monetary policy just about as far as it can go. The Fed has pushed short-term interest rates to the “zero lower bound” and yields on long-term Treasuries to historic lows. Each fresh salvo has less impact than the one before. A study by the Federal Reserve Bank of New York points out that mortgage rates haven’t fallen as much as they should have, given the drop the Fed has managed to engineer in rates on mortgage-backed securities. And businesses aren’t using cheap long-term funds to expand, as Jeremy Stein, a Harvard University economist who is a newcomer to the Fed’s Board of Governors, observed in a Nov. 30 speech. They’re more likely to use the proceeds to pay off short-term debt or pay dividends.
For Washington, there’s an opportunity in this unusual situation. Just as monetary policy loses effectiveness, fiscal policy has become more potent than ever. Ordinarily, Congress can’t boost gross domestic product much through deficit spending because its extra borrowing raises interest rates, crowding private borrowers out of the market. Today there’s no risk of crowding out because there are lots of idle resources—labor, machinery, and money. The Fed will keep long-term rates down no matter how much the government borrows.
It pains deficit hawks to hear this, but ever since the 2008 financial crisis, government red ink has been an elixir for the U.S. economy. After the crisis, households strove to pay down debt and businesses hoarded profits while skimping on investment. If the federal government had tried to run balanced budgets, there would have been an enormous economywide deficit of demand and the economic slump would have been far worse. In 2009 fiscal policy added about 2.7 percentage points to what the economy’s growth rate would have been, according to calculations by Mark Zandi of Moody’s Analytics. But since then the U.S. has underutilized fiscal policy as a recession-fighting tool. The economic boost dropped to just half a percentage point in 2010. Fiscal policy subtracted from growth in 2011 and 2012 and will do so again in 2013, to the tune of about 1 percentage point, Zandi estimates.
It could have been worse. President Obama has been a smarter slump fighter than British Prime Minister David Cameron. The Tory vowed to reduce budget deficits by curtailing spending. But the government’s cuts weakened the economy, clipping 2012 growth to roughly zero. It’s hard to balance the budget when the economy is that weak: For all its painful austerity, Britain’s deficit-to-GDP ratio is no better than America’s. And you say “trillion-dollar deficit” like it’s a bad thing!
The Tea Partiers and Blue Dogs who rail against deficits warn that the U.S. risks becoming another Greece. The difference is that for Greece, austerity is a brutal necessity; the International Monetary Fund and other official sources that are providing funds to the country insist on it. The U.S. has no such constraint. Investors are so eager to lend money to the U.S. that the Treasury can issue 10-year inflation-protected securities at an interest rate of –0.75 percent. The U.S. has the breathing room to spend what’s needed to raise the economy’s long-run growth potential, whether it be stepping up government-sponsored research and development, fixing roads and bridges, or fully funding Head Start.
Early in 2012, two prominent Democratic economists argued that when interest rates are at zero, stimulus can actually pay for itself by increasing economic activity. It was the left’s counterpart to the right’s argument that tax cuts can pay for themselves by juicing up growth. The case appeared in a Brookings Institution paper by J. Bradford DeLong of the University of California at Berkeley and Lawrence Summers, who was President Clinton’s Treasury secretary and National Economic Council director for part of President Obama’s first term. Their case for stimulus hinges partly on the danger of hysteresis—the idea that weakness begets more weakness. Laid-off workers lose skills and become unemployable, causing unemployment to remain high. In the presence of hysteresis, there’s a big payoff from bringing unemployment down as quickly as possible. DeLong and Summers also say that in today’s weak economy, increased government spending has a bigger-than-usual bang for the buck. In technical terms, the “multiplier” is high. Valerie Ramey, a University of California at San Diego economist who was designated to comment on the paper, responded that the economists may have used overoptimistic estimates for hysteresis and the multiplier. In a Jan. 1 e-mail, DeLong stood by their paper. He was scheduled to continue his argument for more stimulus in San Diego on Jan. 6 at an American Economic Association session also featuring Ramey and Paul Krugman.
Those who condemned the budget deal, from the left and the right, focused on its mix of tax hikes and spending cuts. Supply-siders regard tax increases as a worse method of budget-balancing than spending cuts because they reduce incentives to work. Keynesians regard tax increases as a better choice because they reduce demand less than an equivalent dollar amount of spending cuts would. Especially at the high end of incomes, people keep spending even when their taxes go up.
As a first cut, though, ideology is irrelevant. What matters most to the economy’s growth rate is the total amount of deficit reduction, not the means of achieving it. On that score, things could have turned out a lot worse. The economy would have fallen into a recession in the first half if the scheduled fiscal cliff measures had gone fully into effect. Assuming House Republicans don’t achieve big spending cuts in March, economists look for 2013 growth of about 2 percent.
Strangely enough, then, congressional gridlock may have kept lawmakers from doing even more damage. Republicans managed to stave off big tax hikes, and Democrats have so far prevented big spending cuts. As a result, the U.S. was spared a British- or Greek-style dose of austerity. What’s normally a recipe for irresponsibility is helpful in this depressed economy, when the greatest danger is being overly virtuous. But the risk of screwing things up remains as long as the recovery is fragile and austerians are fired up. As Senator Joe Manchin III, a freshman Democrat from West Virginia, put it shortly before the new year: “Something has gone terribly wrong when the biggest threat to our American economy is the American Congress.”