Download the audio of Capital Comments: MP3, WMV
Looking Over the Fiscal Cliff
Economics is not an experimental science. We can't say to Congress, "Honorable ladies and gentlemen, please drastically raise taxes and cut spending all at once so we can measure the effects on the economy of changes in the federal government's budget." This is not what elected officials do.
Except that's just what is scheduled to happen come Jan. 1, 2013.
What a great experiment! Think how much we'll learn. Unfortunately, we'd all have to live inside this experiment. We would be the mice in the maze.
It's the famous fiscal cliff, of course. Come Jan. 1, the Bush-era tax cuts expire, so everyone's tax rates will increase. The two-year cut in the Social Security payroll tax will expire, raising taxes some more. The Alternative Minimum Tax won't be adjusted for inflation, so millions of people will see their taxes rise still more. Automatic spending cuts will kick in, reducing both defense and entitlement spending. Extended unemployment insurance will expire; so two million people will lose benefits. And Medicare payment rates to doctors will be cut. You can get the amazing details from the Congressional Budget Office in its annual budget and economic projection, at http://www.cbo.gov/publication/43539.
Add it up; these changes will yank about $500 billion out of the economy. Higher taxes and lower entitlement payments will cut spending by households and businesses. Government will spend less, laying off employees and cancelling contracts with businesses. With spending down, businesses will have less reason to produce goods and services, so they'll cut production and reduce employment.
The spending loss amounts to about 3 percent of the economy. Since output has been growing less than 3 percent per year, the loss of that spending will turn growth negative. That's a recession. The CBO projects a half-point decline in gross domestic product by the end of 2013, with the unemployment rate climbing back above 9 percent.
But wait! With higher taxes and lower spending, the federal budget deficit will decrease, and we'll add less to the national debt. That's a good thing, right?
Yes it is. The CBO projects that the higher tax rates and lower spending will begin to reduce the national debt as a share of GDP. By 2020, the debt will be down to 61 percent of GDP and falling. Now, it's 73 percent and rising.
When taxes are less than spending, the federal government borrows the difference. Eventually, with too much borrowing, lenders will only lend at higher interest rates. Higher rates reduce borrowing by businesses. Investment projects that would have added new equipment and better technology don't get done. Economic growth slows down. The Federal Reserve may try to hold interest rates down by increasing the money supply, but that leads to inflation.
It's a nasty choice: recession and unemployment now, or high interest rates, inflation and slower growth later.
There may be a way to avoid this nastiness. Deficits are not causing problems now. We've been running huge deficits since 2008, yet lenders still are falling all over themselves to lend to the federal government. Interest rates are at record lows. Inflation is low, too, despite trillions in new money created by the Fed. The problems we expect to see from all that borrowing are nowhere to be found.
That's because an economy trying to emerge from recession is different from one that's fully recovered. We've got unused capacity - workers without jobs, buildings without tenants, factories closed or producing less than they could. That keeps wages, rents and prices from rising, so we don't get inflation. Banks have money to lend but don't see enough low-risk borrowers. Money not lent is money unspent, so it doesn't add to economic growth. Federal government borrowing and spending in an economy like this gives businesses a reason to produce and hire. It doesn't crowd out private investment.
Deficits now are OK. They help our economy. Congress needs to agree to keep taxes down and maintain spending in 2013. Once the economy has recovered, we'll need to bring down those deficits to prevent high interest rates and inflation. Congress needs to agree on a plan to get that done.
Forget the experiment. We aren't mice in a maze. We aren't lemmings on a cliff, either.