CBO Warns About the Fiscal Cliff

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The Congressional Budget Office (CBO) has released an excellent analysis on the “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013.”  The CBO term “fiscal restraint” has been more popularly referred to as “the fiscal cliff.” That is because there are so many large, sudden fiscal policy changes awaiting us at the turn of the year that if we think of the U.S.

The Congressional Budget Office (CBO) has released an excellent analysis on the “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013.”  The CBO term “fiscal restraint” has been more popularly referred to as “the fiscal cliff.” That is because there are so many large, sudden fiscal policy changes awaiting us at the turn of the year that if we think of the U.S. economy as a train, it is heading straight for a dramatic fall-off in consumer demand (and hence in overall activity in an economy still constrained by inadequate demand) as these policy changes all happen at once.

Some of the main changes we will face are the expiration of the 2001 and 2003 tax cuts, the expiration of the payroll tax cut, and the beginning of automatic spending cuts required by the debt limit law passed last August. The concern is that taking so much money out of the economy at one time, through either tax increases or a reduction in government spending on goods and services, would slow consumer spending. That would reduce businesses’ desire to increase hiring, which would lead to continued high unemployment. 

And yes, the worry is that the rapid deficit reduction will be harmful. As I explained in my last Concord blog post, the economic effects of deficits — and the question of when to decrease them — depend on the state of the economy and the timing, size and structure of deficit reduction.

The CBO analysis validates the concern over rapid deficit reduction given the current (continued) economic weakness. First, CBO defines the fiscal cliff as $607 billion worth of deficit-reducing policy changes in one year (enough to cut the deficit nearly in half between fiscal years 2012 and 2013). CBO then explains that this would slow our economy down and perhaps even cause the feared “double-dip recession.” 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.

The net amount of deficit reduction achieved would be $560 billion after taking into account the fiscal effects of a slower economy. Those effects include lower tax revenues, as people earn less or remain unemployed (without wages on which to pay taxes), and higher spending on things like unemployment benefits and food stamps. 

So CBO then looks at the question: What if we could avoid that cliff entirely?  Well, that would indeed keep the economy’s momentum growing 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.

That sounds good: Avoid the fall-off in demand and the resulting double-dip recession by simply bypassing the fiscal cliff. But, this policy choice is not so simple; it has some other consequences. As CBO explains, once unemployment returns to normal and economic growth is steadied, one of the economy’s longer-term ailments — structural long-term deficits — becomes a dominating constraint:

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.

The CBO conclusion about the option that makes the most fiscal sense is one that has been echoed by Concord throughout the recession and by others like the Bowles-Simpson and Rivlin-Domenici bipartisan commissions:

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.

Ultimately, we must reduce the deficit. Plowing straight ahead over the cliff in January 2013, however, would be bad fiscal policy. On the bright side, the need to deal with the policies comprising the cliff within the next six months is an opportunity to take a more constructive attitude toward deficit reduction. We can hope that our policymakers will have the wisdom and courage and work ethic needed — as well as that convenient, scary deadline — to start turning that fiscal cliff into something our economy can more easily and successfully maneuver.

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