Washington is fixated with the so-called “fiscal cliff” of legislated spending reductions and expiring tax cuts scheduled for 2013, which are projected to induce a recession if they materialize. As my colleague Josh Bivens and I have repeatedly explained in a series of recent papers and blog posts, this “cliff” simply represents the macroeconomic reality that budget deficits closing too quickly—thus public debt accumulating too slowly—will, if left unaddressed deep into 2013, push the U.S. economy into an austerity-induced recession. Last week, we released a paper, Navigating the fiscal obstacle course, offering our policy recommendations for moderating the pace of deficit reduction and sustaining recovery by reshuffling various components of the fiscal obstacle course (cliff is a terrible metaphor as it implies a false dichotomy). Now it’s worth zooming out and placing this debate in its proper context: in a depression.
FULL ANALYSIS FROM EPI: Budget battles in the lame duck and beyond
Paul Krugman’s latest book, End This Depression Now!, wasn’t hyperbolically titled—the United States truly is in a depression. U.S. economic output is currently depressed $973 billion below potential economic output—what the economy could produce with higher (but noninflationary) levels of employment and industrial capacity utilization. The U.S. economy has operated at 5 percent or more below potential output since the fourth quarter of 2008, and today’s output gap remains at 5.8 percent of potential GDP. Furthermore, the economy is growing too slowly to close this “output gap” between actual and potential economic activity.
In order to close the nearly $1 trillion output gap—that is, to move the U.S. economy fully out of depression—actual economic growth must outpace growth in the economy’s potential output (i.e., growth in potential productive capacity from rising productivity and labor force growth). Overall, real GDP growth has averaged 2.1 percent since recovery began in mid–2009, whereas the Congressional Budget Office (CBO) projects that growth in the economy’s real potential output will average 2.2 percent over 2012–2022. (The pace of growth has also clearly decelerated, with annualized real growth in the first three quarters of 2012 clocking in at 1.7 percent, down from 2.0 percent in 2011, 2.4 percent in 2010, and 2.7 percent in the second half of 2009.) Markedly faster growth is needed to restore full employment and have actual GDP revert to potential output, rather than potential output reverting to depressed actual output through economic scarring. In the near term, the pace of growth will be overwhelmingly driven by fiscal policy, and fiscal policy is poised to be quite contractionary (i.e., the Federal Reserve is in no position to cushion “going over the cliff”).
The figure below charts the output gap between potential and actual GDP through the third quarter of 2012, and then models three scenarios for the fiscal obstacle course (all in chained 3Q2012 dollars). CBO’s current law forecast—i.e., going over the “cliff”—would decrease real GDP by 0.5 percent over the year, resulting in an output gap of $1.3 trillion by the end of 2013. I’ve also adjusted this current law forecast with the economic activity we project would be generated by maintaining current policy—continuing all temporary tax cuts except the payroll tax cut, continuing the “doc fix,” and repealing the sequester—from Table 1 of our recent paper, A fiscal obstacle course, not a cliff.1 Even under this “current policy” baseline, real GDP is projected to grow just 1.4 percent and the output gap would rise above $1.0 trillion by the end of 2013.
Lastly, I’ve added a baseline titled “dodge the cliff.” This basically just “turns off” the three major fiscal obstacle course components that would be allowed to drag on growth if Congress followed the current policy baseline—expiration of emergency unemployment benefits, expiration of the payroll tax cut, and discretionary spending caps ratcheting down. Under this last scenario, real GDP growth would rise to 3.1 percent for the year—better for sure, but the output gap would still be $734 billion by year’s end.
So, the parameters of this debate over fiscal contraction seem to be about whether the U.S. economy will be 7.7 percent or 4.3 percent (or somewhere in between) below potential output a year from now. Note that nearly half (47 percent) of the projected fiscal drag will hit even under a continuation of current policy.
What does this all mean? Simply that a full recovery would require ambitions well beyond reshuffling the various elements of the fiscal obstacle course; the “reshuffling” recommendations in our new paper essentially get to the “dodge the cliff” scenario in the figure above, but with a different mix of stimulus and without creating a subsequent “cliff” in 2014 or 2015. Full recovery will only occur in the near term if fiscal policy becomes much more supportive of growth in the coming years (i.e., if budget deficits rise substantially). It would also require ambitions unconstrained by the misguided political demand that any near-term fiscal support be paired with longer-run deficit reduction. Merely continuing the Bush tax cuts and preventing sequestration from materializing (the most fixated upon components of the “cliff” discourse, and both of which are assumed under current policy) would mean a larger depression a year from now than today. Actually closing the $1 trillion output gap (the barometer for restoring full employment) projected for 2013 under current policy would take roughly $700 billion in cost-effective, deficit-financed fiscal stimulus in 2013 alone, which regrettably seems politically unachievable.
To be explicit: The fiscal obstacle course debate is intrinsically fixated on maintaining anemic growth versus falling into a recession, not ending this depression. As a rough compass, policymakers need to target real GDP growth above 2.2 percent if this depression is to eventually be ended.
1. CBO’s quarterly forecast of annualized GDP has been adjusted for the net impact of policy alternatives as we projected for the end of calendar year 2013. The GDP spike in the first quarter of 2013 followed by contraction is a reflection of a deepening economic contraction under the current law baseline—a smoother trajectory to the same fourth quarter of 2013 end point would be expected in the first half of the year under the alternative policy scenarios.