The U.S. Economy After the Fiscal Cliff

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Dean Baker
The Hankyoreh (South Korea), January 9, 2013

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Most of Washington was caught up in a near panic at the end of 2012 over the fear of falling off the dreaded “fiscal cliff.” This was a mix of $500 billion in tax cuts scheduled to expire at the end of the year coupled with roughly $150 billion in spending cuts that were supposed to kick in. Projections from the Congressional Budget Office and other independent forecasters showed that the combined impact of higher taxes and lower spending would throw the economy back into a recession, if left in place all year.

The “left in place all year” part is the key here. The stories of the dire consequences of the fiscal cliff referred to what would happen if these budget changes remained in place, with Congress taking no action all through 2013. However the debate in Washington was centered on the view that a recession would result if a deal was not struck before midnight on December 31. (The deadline was in fact missed by 2 days.)

The extent to which this fabrication became accepted reveals a great deal about the state of policy debate in Washington. The distinction between higher tax rates and lower spending being in place for a full year, as opposed to a few days or weeks, is about as simple as it gets.

Over time, the higher taxes will be a drag on consumer purchasing power leading to a falloff in demand. Similarly, a lower rate of government spending means that public sector workers will be laid off, raising the unemployment rate and reducing their purchasing power.

However, higher tax rates will have little impact if they are only in effect for a few weeks, especially if the extra taxes are later refunded as the result of a budget deal. Also, the pace of government spending would probably not even change, if it was just a matter of weeks for Congress and the President to hammer out a deal.

In short, the consequences of missing the December 31 deadline were essentially zero. Yet, the media built up this deadline as a momentous event, convincing much of the public that there would be enormous consequences if there was no deal by this date.

This fundamental misrepresentation of reality increased pressure on President Obama to make a deal before the end of the year when his bargaining power was weaker. He would have had more bargaining power if the deal was struck in 2013, after the tax hikes had already gone into effect and a new Congress was seated on January 3rd.

This misrepresentation of reality is unfortunately also characteristic of the larger debate on the budget and economic policy. There is an endless drumbeat in the media on the budget deficit, with nearly all of the reporting implying that there is a chronic imbalance of spending and taxes.

In reality, the large budget deficits of recent years are entirely attributable to the economic downturn caused by the collapse of the housing bubble. The deficits were small prior to the downturn with the debt to GDP ratio actually declining. The debt to GDP ratio was projected to continue to decline into this decade, even if the tax cuts put in place by President Bush were not allowed to expire.

This situation was radically altered by the downturn. Tax collections plummeted, while spending on countercyclical policies like unemployment insurance increased. In addition, there were large tax cuts and spending increases put in place as temporary stimulus measures to boost the economy. However, there were no permanent tax or spending changes of any consequence. This means that if the economy was operating near its potential, the deficit would be at a sustainable level.

This fact would suggest that the deficit is not a current problem and that the focus for economic policy should be getting the economy back near full employment. Unfortunately full employment is not on the table. Even worse, the measures intended to reduce the deficit “problem” will inevitably have the effect of slowing the economy and raising the unemployment rate.

As it stood, the U.S. could have perhaps anticipated a growth rate of 3.0 percent in 2013, if there were no changes to taxes or spending. The Congressional Budget Office estimates that the economy is currently at a level of output that is 6.0 percent below potential GDP. With potential GDP growing at a 2.4 percent annual rate, a 3.0 percent growth rate would allow us to close the output gap in a decade.

However, the tax increases and spending cuts that have already been put in place will knock close to 0.5 a percentage point from GDP growth. Further cuts that are likely to implemented later this winter could push the growth rate down to 2.0 percent or lower meaning that actual growth would not be keeping pace with the economy’s potential, thereby raising unemployment and making the output gap larger.

That would be a horrible tragedy since it means needlessly inflicting pain on millions of people. But no one cares about reality in Washington, they just want deficit reduction.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The End of Loser Liberalism: Making Markets Progressive. He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues.