A grim surprise was tucked inside the Congressional Budget Office’s latest budget outlook. Economic growth, it said, would be only 2 percent in 2012, falling to 1.1 percent in 2013. That’s horrible.
It’s far beneath the growth rate required for the economy and job market to recover. But it’s also probably wrong — provided that Congress wants it to be wrong. Because the CBO isn’t saying the economy can’t grow faster than that. It’s saying the economy won’t grow faster unless Congress makes some hard decisions, and soon.
The CBO has to do something most of us don’t: Read the laws as they are currently written and take them seriously. If you do that, you realize there are a series of fiscal bombs set to go off over the next year. In a few weeks, for instance, the payroll tax cut and expanded unemployment benefits are set to end. On Dec. 31, all of the Bush tax cuts are scheduled to expire, and the $1.2 trillion automatic sequester from last year’s Budget Control Act is supposed to begin slicing federal spending. Many smaller policies are also set to expire or phase out this year.
Economists call this “fiscal drag.” They mean it literally — that fiscal policy is dragging down the economy. In this case, the fiscal drag is huge. Without it, the CBO estimates a much rosier few years for the U.S.: growth of about 2.5 percent in 2012, and 2.75 percent in 2013. Those aren’t amazing numbers, but they’re a lot better than the alternative scenario.
Adding to Worry
The CBO isn’t the only institution worried about fiscal drag. In a report released Jan. 24, the International Monetary Fund warned that, before we even get to the expiration of the Bush tax cuts and the cuts required by the sequester, fiscal drag in 2012 will be as high as 2 percent of GDP — “the largest annual fall in at least four decades.” This is partly due to the aforementioned bombs, like the potential end of the payroll tax cut, but also due to the stimulus bill mostly finishing its spending in 2011, Congress choosing lower spending levels for 2012 and much else. This drag, they dryly observe, will have “negative repercussions” for the economy.
But there’s another side to this coin: If we simply let the fiscal bombs go off — meaning spending is cut and taxes rise — the deficit pretty much disappears. The CBO estimates that it would fall from 7 percent of GDP this year to roughly 1.5 percent over the next few years, one of the fastest reductions in American history. Conversely, if we defuse all the fiscal bombs, deficits will remain high — about 5.4 percent of GDP.
So it seems Congress faces a stark choice between growth and deficits. Lawmakers can do nothing and watch the deficit mostly vanish. Or they can act and watch the debt mount. Happily, the situation is not quite so dire.
Reducing deficits at the expense of growth rarely has the impact that governments intend. After all, the goal of reducing the deficit is to reduce borrowing costs. But, as the IMF notes, “while smaller deficits and debt ratios do lead to lower borrowing costs, other things equal, advanced economies with faster output growth are also currently benefiting from lower spreads.” In other words, the market is more concerned with growth prospects than it is with deficits, at least for now.
Which makes sense: Deficit reduction is largely impossible without economic growth. Note the struggles of the U.K., which has embraced austerity more fully than perhaps any other major economy, only to see its growth falter and its total debts rise.Space to Deleverage
The U.S., by contrast, has permitted public debt to rise in an effort to protect growth. That’s given the private sector space to deleverage. The result, as the McKinsey Global Institute detailed in a recent report, is that the total debt load in the U.S. — which combines both public and private debts — has fallen by 16 percent, leaving the U.S. further along the painful deleveraging process than any other major economy.
That doesn’t mean the public sector’s deficits should, or can, be ignored. As the McKinsey study says, history suggests that recovering from a financial crisis requires a two-stage deleveraging process: First, the private sector sheds debt while the public sector adds debt and drives growth, and then the private sector drives growth while the public sector sheds debt. But as the IMF notes, American policy, right now, has this backward: “The risk of too rapid short-term adjustment stands in marked contrast to the continued lack of progress in clarifying a medium-term consolidation strategy.”
The right strategy is to make growth the priority over the next few years while putting in place a credible, clear strategy for deficit reduction in the years after that. That’s entirely in Congress’s power. Lawmakers could pass a single bill that includes a short-term growth component to extend and expand the payroll tax, invest in public works projects and defuse the fiscal bombs, and a longer-term deficit reduction component, perhaps along the lines of the Bowles-Simpson plan, that cuts the deficit by more than $4 trillion beginning in 2014. What markets would hear in that case is a commitment to the best of both worlds: a more robust recovery now, deficit-reduction soon. That’s much more reassuring than the message markets are getting now, which is that current U.S. policies are configured to give us the worst of both worlds, and that Congress is too paralyzed to change course.
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