Goldman Sachs: Best Way to Survive the ‘Fiscal Cliff’ Is Sending Obama, Republicans Back to Washington

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Market observers are worrying about a new obstacle in the path of economic recovery: America’s impending “fiscal cliff.” Economists from Fed Chairman Ben Bernanke to Alan Blinder have been warning of the $600 billion that will be sucked out of the U.S. economy – through a combination of tax increases and spending cuts – at the end of 2012 if current law is allowed to stand. These policies would reduce economic output by more than 3% in 2013 – enough, by some measures, to put the U.S. back into a recession. As Mark Zandi, chief economist at Moody’s Analytics, wrote last week:

While the federal government needs to tighten its belt to stabilize the nation’s debt-to-GDP ratio over the long term, the sharp spending cuts and tax increases coming next year would be hard to absorb even with a robust economy. The amount of fiscal braking the U.S. can withstand — before growth slows so much that it hurts rather than helps the push for fiscal sustainability — is closer to 2 percentage points of GDP.

In other words, we need to make some changes to the budget, but doing them all in one shot is unnecessary and potentially fatal to the recovery. In an ideal world, we would gradually raise taxes and reduce spending until the budget deficit is at a manageable level and do so in a way that allows the private sector time to pick up the slack. Of course, our elected officials rarely act in a way that economists think ideal. But in a time like this, when the economy depends so much on decisions before Congress, those whose job it is to forecast the economy must also be in the business of forecasting elections and congressional behavior. A tricky task indeed, but one that Goldman Sachs has undertaken in a research note published last week.

(MORE: Obama’s Job Creation Tax Credit: Cool Idea, Bad Policy)

Goldman handicapped the outcomes given the new political landscape we’ll have in less than a year, and its findings are somewhat counterintuitive. Specifically, Goldman predicts that a more moderate deficit reduction would most likely occur after a “status quo” election – one in which both President Obama and House Republicans remain in power.

Most Americans would be surprised at the idea that sending the current cast of lawmakers and the same President back to Washington would be a good way to achieve compromise and a fiscally sustainable budget. But remember, a lot of the stuff lawmakers don’t like to do (raising taxes and cutting spending) has already been written into law. The best course of action now, according to some economists, is to moderate those actions a bit by partially extending the Bush tax cuts and spreading out the effects of spending cuts over a number of years.

Goldman’s thinking is that handing the reins over solely to Democrats or Republicans would tempt that party to go too far in one direction or the other — too much tax cutting, in the case of the Republican Party, or too much spending, in the case of the Democrats. And so, by returning a divided government to Washington, we may get just the right amount of gridlock to avoid any shocks to the nascent recovery.

Another possibility not addressed in Goldman’s note is that voters could throw all the bums out and put Democrats in control of Congress, while installing a Republican, most likely Mitt Romney, in the White House. This is rather unlikely given the number the seats Democrats would have to win to maintain their Senate advantage and take the House, but it may be the best possible scenario for reducing the deficit responsibly, without the sort of theatrics that jarred world markets last summer. Mitt Romney has shown a willingness to raise revenue, and the conventional wisdom is that congressional Democrats are more apt to cut spending than congressional Republicans are to raise taxes. A compromise between a Democratic Congress and a Republican President could echo George H.W. Bush’s 1990 deficit-reduction deal, which many credit with laying the groundwork for the balanced budgets of the 1990s.

Goldman Sachs thinks our current, divided government is the best path to deficit reduction. Divided government maybe, but perhaps the best plan for voters is to divide government the other way around.

MORE: The 97-Pound Recovery: Can the Economy Get Back to Fighting Weight?

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