While Congress is on recess and both major political parties are gearing up for their conventions, the Congressional Budget Office on Wednesday issued a stark reminder of the danger posed to the U.S. economy by the set of budget cuts and tax increases set to go into effect after the new year.
These budget measures, popularly known as the “fiscal cliff,” will cut more than $500 billion from the deficit, money that would come directly from a convalescent economy, most likely forcing the U.S. back into recession, according to CBO forecasts. As it stands, on January 1 the following cuts and increases will go into effect:
- The expiration of the Bush tax cuts for every tax bracket;
- The expiration of a 2% cut in payroll taxes enacted by President Obama and Congress in 2010 and extended again earlier this year; and
- Spending cuts to Medicare, defense and other discretionary spending as part of Congress’s and the Obama Administration’s deal to raise the debt ceiling last summer.
(MORE: Goldman Sachs: Best Way to Survive the ‘Fiscal Cliff’ Is Sending Obama, Republicans Back to Washington)
With federal debt held by the public reaching 73 percent of GDP, and yearly deficits recently topping $1 trillion, it’s almost unanimously agreed upon that the U.S. has a long-term debt problem. But most economists and policy analysts believe that the debt situation isn’t bad enough that it can’t be addressed in a more gradual and careful manner than current law allows. Economist Ed Dolan argues that the federal government needs to strike a “Goldilocks Budget Deal” that paves a path between the fiscal austerity mandated in current law and a kicking-the-can-down-the-road approach of delaying spending cuts and tax increases indefinitely. Writes Dolan:
“The Goldilocks outcome of fiscal consolidation that begins immediately but is phased in gradually as the economy recovers will require political compromise. The components of compromise are known to everyone:
- Tax reform that increases revenues while broadening the base and reducing the disincentives inherent in high marginal rates.
- Discipline regarding both defense and nondefense components of discretionary spending without compromising growth-enhancing expenditures like education and infrastructure.
- Reform of social security and Medicare that recognizes both budgetary and demographic realities.”
Congress and the White House still have time to tackle the fiscal cliff, which doesn’t go into effect until 2013. But the economy may already be suffering from the effects of uncertainty imposed by such extreme policy changes looming over our heads. According to economists surveyed by The Wall Street Journal last week, businesses are pulling back from hiring and investment until they know for certain what tax and spending policies will come out of Washington.
Of course, there is another important player in economic policy in Washington: the Federal Reserve. Under normal circumstances, the central bank could cushion the blow dealt by fiscal contraction through lowering interest rates. Short-term interest rates have been near zero for several years now, but the Fed showed its willingness to engage in another round of bond buying — so-called QE3 — which would aim to push down long-term interest rates as well. On Wednesday the Federal Reserve released minutes from its meeting held earlier this month, which said:
“Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”
But even if the Fed expands its balance sheet, it’s unclear whether it has the ability or willingness to engage in the kind of open-ended asset purchases that would be necessary to absorb all of the effects of the looming fiscal cliff. One thing is for sure, the U.S. economy is unfortunately and irrevocably tethered to the American political process, a process that historically becomes increasingly hysterical and unpredictable as a presidential election nears.