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Turning the Fiscal Cliff Into a Gentler, Climbable Hill

May 23rd, 2012 . by economistmom

little-engine-that-could

The Congressional Budget Office has just released an excellent analysis prepared by CBO economist Ben Page on the “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013″ (in typically dry CBO-speak).  I prefer to think of it as an economics version of the story “The Little Engine That Could.”  You see, the “engine” is the U.S. economy, and this so-called “fiscal cliff” is, rather than something we are in danger of falling off of, something we are about to ram straight into–like a huge wall just ahead on the tracks, at January 2013.  When economists and policymakers fret about this fiscal cliff, it’s not the usual worrying about the unsustainable deficits we are projected to run over the next several decades; it’s concern that our economy, still in “recovery,” can’t handle the amount of deficit reduction that is scheduled to be forced upon us in just a matter of months.

The CBO analysis validates this worry, first defining the scale of the cliff as $607 billion worth of deficit reduction in one year (or $560 billion net of economic feedback, cutting the deficit nearly in half between fiscal years 2012 and 2013), then explaining that letting our economy run head onto this cliff will in fact, slow it down and perhaps even cause the “double-dip recession” economists have been fearing.  From the summary (emphasis added):

Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.

So CBO then looks at the question: what if we could avoid the cliff entirely–by sort of going around it?  Well, going around it would indeed keep us going in 2013:

CBO analyzed what would happen if lawmakers changed fiscal policy in late 2012 to remove or offset all of the policies that are scheduled to reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013. In that case, CBO estimates, the growth of real GDP in calendar year 2013 would lie in a broad range around 4.4 percent, well above the 0.5 percent projected for 2013 under current law.

So that sounds, good: if we can’t go through the fiscal cliff, just go around it (or just say “poof” and imagine it away).  OK, I’ll take that ticket… Except, as CBO next explains, then the inevitable (real) “cliffs” ahead just get taller and steeper:

However, eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would reduce output and income in the longer run relative to what would occur if the scheduled fiscal restraint remained in place. If all current policies were extended for a prolonged period, federal debt held by the public—currently about 70 percent of GDP, its highest mark since 1950—would continue to rise much faster than GDP.

Such a path for federal debt could not be sustained indefinitely, and policy changes would be required at some point. The more that debt increased before policies were changed, the greater would be the negative consequences—for the nation’s future output and income, for the burden imposed by interest payments on the federal debt, for policymakers’ ability to use tax and spending policies to respond to unexpected challenges, and for the likelihood of a sudden fiscal crisis. And the longer the necessary adjustments in policies were delayed, the more uncertain individuals and businesses would be about future government policies, and the more drastic the ultimate changes in policy would need to be.

You see, even over the longer term, the “fiscal cliff” is more like one we will have to climb rather than one we’re in danger of falling off of.  And the higher the cliff gets, the harder it will be in the future to ignore it or continue to go around it, or actually get up it.  So going around and avoiding the cliff entirely isn’t a long-term option, nor necessarily the best option even now.  CBO explains the policy options, which I’m labeling as different strategies for driving the train called the U.S. economy toward the 2013 fiscal train stop.  The CBO concludes that there are three basic options (my labels and emphasis added):

What Might Policymakers Do Under These Circumstances?

[1: "Going Around the Cliff, For Now"]  They could address the short-term economic challenge by eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years—but that would have substantial economic costs over the longer run.

[2: "Running Head-On Into the Cliff"]  Alternatively, they could move rapidly to address the longer-run budgetary problem by allowing the full measure of fiscal restraint now embodied in current law to take effect next year—but that would have substantial economic costs in the short run. Or,

[3: "Grading the Cliff Into a Climbable Hill"]  if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies: changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period.

In other words, the U.S. economy does face an “uphill battle” in terms of the fiscal outlook; heading to higher ground (meaning lower deficits), eventually, is unavoidable.  But to quote from a particularly wise engine, “I think [we] can” do it.  The 2013 fiscal cliff is at least an opportunity to take a constructive attitude toward climbing that hill, and hopefully our policymakers, after the election, might have the wisdom and courage and work ethic needed to start turning that fiscal cliff into something our economy can more easily and successfully climb.

6 Responses to “Turning the Fiscal Cliff Into a Gentler, Climbable Hill”

  1. comment number 1 by: SteveinCH

    Except that they have no credibility on option 3. So next year, option 3 will look a lot like option 1 and the year after and the year after.

    Beyond which, I can’t see a path to option 3 happening, at least on the tax side. The chips are going to fall like this, at least in my view.

    Step 1: The Republicans in the House pass a bill extending the current income tax code but not the payroll tax change for another 2 years (I think this is on the floor or already done).

    Step 2: The Democrats whine and complain about tax cuts for the rich and pretend that most of the tax cuts are for the rich (as opposed to about 10% of them when you combine the income and payroll tax changes).

    Step 3: Nothing passes in the Senate, indeed nothing even comes to the floor and the rhetorical war wages back and forth.

    Step 4: There’s a choice that comes - it will be either all or nothing, the Dems are going to have to try to push a bill through the Senate at some point (probably in the lame duck) and the question will be whether enough Dems will line up to oppose a full extension. The two possible outcomes in the Senate (at least in my view) are a full extension or nothing.

    5. Assuming either outcome, Dems will then immediately pass through the Senate an extended payroll tax cut because in either case, the “middle class” must be protected.

    6. The House will hem and haw but will ultimately go along with the Senate on the payroll tax.

    7. The President, if he wins again, will sign both bills although if he loses, he might veto the income tax bill.

    And the dance goes on.

  2. comment number 2 by: Vivian Darkbloom

    Steve,

    There is a technical issue involved with respect to your Steps 4 and 5. Under the origination clause of the Constitution, all “all bills for raising revenue” must be initiated in the House. In the past, the House has interpreted a “bill for raising revenue” to include bills that not only *raise* revenue (increase taxes), but also bills that *affect* revenue, at least revenues that go into the general fund.

    Of course, even if the Senate would be precluded from initiating and passing such a bill and sending it to the House, nothing would prevent them from trying. The most likely response would be that the House would “blue-slip” the bill and send it right back, citing the origination clause as the reason for not acting.

    Whether the origination clause would be in play would, of course, depend on the precise content of any Senate bill; however, by your description, I would guess the issue might very possibly arise.

    The CRS wrote a recent (2011) memo on this topic:

    http://www.fas.org/sgp/crs/misc/RL31399.pdf

  3. comment number 3 by: SteveinCH

    Vivian,

    I suspect it would be like several recent efforts, where the Senate takes the House bill and amends it by replacing it and then sends it back to the House.

    The only way for the House to stop this, as I understand it, is to refuse to pass their own bill in the first place. I doubt this is the approach they will take.

  4. comment number 4 by: Vivian Darkbloom

    Steve,

    Yes, that would be permissable and would presumably be the House bill you mention in Step 1. I did not originally get that (possible) connection from your narrative description of the “steps”.

  5. comment number 5 by: SteveinCH

    You do raise a good point though. Steps 4 and 5 might need to be combined in order to make it work on the Senate side or the Senate would need a different “shell” to use for step 5.

  6. comment number 6 by: Jim Glass

    “under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects … CBO analyzed what would happen if lawmakers changed fiscal policy in late 2012 to remove or offset all of the policies that are scheduled to reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013. In that case, CBO estimates, the growth of real GDP in calendar year 2013 would lie in a broad range around 4.4..”

    The Economist put it this way…

    The bottom line is quite simple, says CBO. If all of the fiscal blow is deflected, the economy should grow at an annual pace of 5.3% in the first half of the 2013 calendar year. If Congress is unable to find a way to defer some of the impact, the economy will instead shrink by 1.3%.

    Except, of course, that the economy will almost certainly not grow at a 5.3% rate no matter what Congress does. Arguments to the contrary are subject to what econ bloggers have come to call the Sumner Critique…

    Which is that whatever fiscal policy is, the Fed can be expected to counter it. This fact has been greatly overlooked in all the arguments about “multipliers”. E.g. if the central bank has a target it wants to hit (inflation level, NGDP, whatever) and ammunition to shoot (Bernanke keeps saying it has plenty) then the fiscal stimulus multiplier is zero, or at least a whole lot closer to it than fiscal stimulus people think.

    And with the fiscal policy multiplier zero or close to it, Congress can do whatever the heck it wants with the budget without affecting the economy or GDP growth (via the demand side, on the supply side higher taxes would hurt but less govt borrowing would help).

    Here’s Sumner himself on this, with a link to the Economist story:

    http://www.themoneyillusion.com/?p=14491
    ~~~~

    From the prior comment thread, Brooks / Gordon:

    On this topic I was referred by a prominent economist (by email, so I won’t give name) to this paper by Brad DeLong and Larry Summers in which they conclude that, under what they “defend as plausible assumptions”, fiscal stimulus in “severely depressed economies” “may well reduce long-run debt-financing burdens”…

    That paper really annoyed me. I wrote something vexed about it in Sumner’s comments and he turned it into a post of his own. “Jim Glass on Larry Summers”.

    http://www.themoneyillusion.com/?p=13736

    For what that’s worth. I am now officially a Sumner fan, he has great taste in comments. :-)