But in August 2011, in an unprecedented breach of Congressional norms, Republicans in Congress instead used the looming breach of the debt ceiling to demand spending cuts. Besides breaching legislative norms, the resulting cuts were also economically disastrous. The Budget Control Act (BCA) of 2011 and the resulting spending austerity (often short-handed not quite accurately as “the sequester”) fully explains why the U.S. economy has yet to reach a full recovery from the Great Recession, even more than six years after the recession officially ended. If we had instead simply followed the average path of federal spending that characterized all previous post-World War II recessions, the U.S. economy would be at full employment by now, and the Fed would have certainly begun raising interest rates a long time ago.

The fiscal drag resulting from the sequester relented a little in the past two years, as the result of a compromise reached between the House and Senate budget committees. But this compromise only rolled back sequester cuts for two years. For fiscal year 2016, the Congressional Budget Office estimates that not extending this compromise and instead returning to 2011 BCA spending targets could cost as many as 800,000 jobs as these cuts drag on aggregate demand.

One would think that loosening this coming fiscal drag would be a high priority for policymakers. Instead, the Republican Study Committee (RSC), a bloc of conservatives in Congress, has made replaying the 2011 debt ceiling crisis a top priority. With their “Terms of Credit Act,” they are demanding cuts over and above the return of sequester level spending levels as just one of many concessions that need to be made to convince them to raise the debt ceiling. The general cuts it demands are $3.8 trillion in cuts to mandatory spending over the next 10 years. Though, as Senator Sheldon Whitehouse pointed out in a hearing today, they are not even serious enough about these cuts to actually identify what should be cut. Instead, it’s simply vague line-items placed next to various congressional committees.

We can, however, get a sense of the lower bound of the fiscal drag that would result in the next year if the RSC proposals were actually put into effect—it’s very roughly $130 billion (add up “resolution changes” in Table 14 here). For next year, this would constitute a very large fiscal drag, something on the order of 1 percent slower GDP growth and 1.1-1.2 million fewer jobs created through the year (for context, job growth in all of 2015 so far has been just under 1.8 million jobs).

Luckily, nobody really takes the RSC that seriously, and the Obama administration has so far signaled that they will reject even the fiscal drag resulting from a snapback to sequestration spending levels, and has not even addressed the truly absurd second layering of cuts called for by the RSC. But it’s a useful reminder that to some in Congress, the 2011 debt ceiling crisis and resulting austerity that has resulted in slow growth and unnecessary economic pain for millions is a model, not a cautionary tale.

This brief documents how recent federal fiscal policies have impacted state budgets through affecting funding levels for federal grants provided to states.1 It begins by analyzing the effects of the $85.3 billion in spending cuts for fiscal 2013 known widely as sequestration. It then examines the combined effects of sequestration and additional funding changes made in the current continuing resolution (CR), or stopgap federal funding bill—thereby providing the fullest picture of how recent federal fiscal policies have affected state budgets for the current fiscal year. This CR, which was signed into law on March 26, funds government agencies through the end of fiscal 2013 (Sept. 30) and ensures funding levels comply with legislated spending levels.2

Principal findings include:

• The sequestration cuts that went into place March 1 decreased federal funding for state grants in fiscal 2013 by $5.1 billion (relative to the continuing resolution in place when sequestration hit).
• The five states with the largest federal grant funding cuts (in percentage terms) due to the March 1 sequestration were Wyoming, Utah, North Dakota, Montana, and South Dakota (relative to the continuing resolution in place when sequestration hit).
• Taking into account both sequestration cuts as well as different funding levels passed under the current continuing resolution, federal grant funding for 25 states (including the District of Columbia) will decline in fiscal 2013 relative to fiscal 2012.
• The five states with the largest percentage funding cuts for federal grants due to both the March 1 sequestration as well as the passage of the current continuing resolution are Louisiana, Indiana, Maine, Connecticut, and Massachusetts. On average, those states face an estimated fiscal 2013 federal grant funding loss of 4.5 percent, or $402 million per state, relative to fiscal 2012. On average those same states experienced positive growth in grants from the federal government over both fiscal 2010–2011 and fiscal 2011–2012.

Background on sequestration and current government funding levels

The levels of federal grant funding made available to states in fiscal 2013 are affected by the sequestration spending cuts that went into effect on March 1 and by the passage of the current continuing resolution, which was signed into law on March 26.

Sequestration resulted from the Budget Control Act of 2011 (BCA), which was signed after House Republicans refused a traditionally pro forma increase in the statutory debt ceiling in 2011 and forced negotiations with the Obama administration over spending cuts. The BCA created a Joint Select Committee on Deficit Reduction (or “Super Committee”) tasked with coming up with $1.2 trillion in deficit reduction over 10 years ($984 billion not including interest savings). To ensure deficit reduction would occur even if the Super Committee failed to agree on specific measures, the backup sequestration procedure was created. This process mandated cuts to defense and nondefense spending, split equally, totaling $109.3 billion annually over fiscal 2014–2021 (Kogan 2013).3 Because the Super Committee did indeed fail to agree on specific spending cuts or tax increases that would have achieved the legislated deficit reduction, the mandated sequestration cuts were triggered for fiscal 2013. They took effect on March 1 after being both postponed by two months and marginally reduced (to $85.3 billion) by the American Taxpayer Relief Act of 2012 (the lame-duck budget deal).

In addition to sequestration, Congress agreed to a new CR to fund government activities, which was signed into law on March 26, 2013. The current CR funds government agencies through September 2013 (the end of the fiscal year). It sets spending levels at $984 billion, a level that complies with limits on discretionary spending legislated by the BCA.

Impact of federal legislation on states

Sequestration and the current CR will affect the amount the federal government contributes to state grants, which provide roughly one-third of total state revenues (Pew Center on the States 2012).4 Though sequestration spares some programs, including Medicaid—which accounts for a large portion of grants to states—many programs operated at the state and local level will feel the effects.5 Each state will experience different impacts, and many will face tough choices concerning how to respond to fiscal contraction.

Impact of sequestration

The March 1 sequestration reduced grant funding from the federal government in each state, as it required across-the-board spending reductions in programs that receive funding in all states (though some programs were exempt from funding cuts).6 The March 1 cuts resulted in a $5.1 billion decline in fiscal 2013 funding for state grants (relative to grant funding in the continuing resolution in place when sequestration hit). When comparing the size of the funding cuts for these grants relative to grant funding in the CR in place March 1, Wyoming, Utah, North Dakota, Montana, and South Dakota experienced the largest percentage declines due to sequestration (Table 1). In addition to presenting the cuts from sequestration as a percentage of grant funding in the CR in effect March 1, Table 1 shows the cuts as a share of 2007 gross state product.7 By this measure, Wyoming, New Mexico, Alaska, Montana, and North Dakota were most heavily affected.

Table 1

Combined impact of sequestration and the current continuing resolution

The March 1 sequester reduced all states’ federal grant funding (relative to prior funding levels). However, the current CR, which was signed into law on March 26 and funds government for the remainder of the fiscal year, resulted in some states receiving total grant funding greater than fiscal 2012 levels, and some states receiving less. Taking into account passage of the CR and the March 1 sequester—thereby providing the fullest picture of how recent federal fiscal policies have affected state budgets in fiscal 2013—25 states’ grant funding (including the District of Columbia’s) is estimated to decline relative to fiscal 2012 levels, while 26 states’ grant funding is estimated to increase. The changes for each state relative to fiscal 2012 funding are presented in Table 2 both as a total loss or gain and as a percent change.

Table 2

Many factors explain why some states experienced decreases and others increases. In regard to grant funding cuts, states can experience different levels of decreases based on both how grants are allocated, and which programs states choose to, or are able to, operate. For instance, some programs only exist in certain states. The WIC Farmers’ Market Nutrition Program, which provides fresh produce to low-income women with young children in the Women, Infants, and Children supplemental nutrition program, is one such example. Funding for states participating in this program declined by 26.4 percent between fiscal 2012 and fiscal 2013 post–sequester and CR passage. Because the 14 states not participating in this program receive no funding for it, they experienced no cuts in funding for the program.

Similarly, other programs are region-specific and thus only exist in certain states. One example is grant funding for the Appalachian Regional Commission, a federal-state partnership that fosters community and economic development in Appalachia. The 13 states that receive grant funding through the program experienced program-specific cuts of 5.03 percent under sequestration, ranging from $7,000 for Maryland to $46,000 for New York. Another example is grant funding provided to 29 states (those bordering oceans and the Great Lakes) for coastal zone management. Post–sequestration and CR passage, these states experienced program-specific cuts of 6.6 percent relative to fiscal 2012 funding levels. Ten states’ grant funding for this program declined by $163,000, while other states experienced smaller cuts.

Another factor explaining why some states experienced increases and others decreases is the nature of mandatory spending programs, such as entitlements and need-based aid. Spending for many mandatory programs is open-ended, meaning the relevant agency disburses funds as required by the conditions set forth in authorizing legislation, with unlimited authority (CBO 2013). In other words, anybody who qualifies will receive funds; such spending is thus sensitive to factors such as economic conditions and demographic changes. Therefore, Congress does not exercise direct control over mandatory spending levels on a yearly basis. Examples involving grants to states include the following:

• Pell Grant funding for each state increased between fiscal 2012 and fiscal 2013 post–sequestration and CR passage, but some states experienced slightly larger percentage increases than others. Financial need for Pell Grants is determined by a formula used by the Department of Education, and anyone who meets the eligibility criteria can receive a grant. Pell Grants are funded partly from discretionary funding and partly from mandatory funding. Federal Funds Information for States (FFIS) data indicate that Pell Grant funding increased in each state relative to fiscal 2012, though that increase ranged from 1.5 percent to 2.3 percent. Ohio received the largest percentage increase (2.3 percent) relative to fiscal 2012, or an increase of $32 million. Florida had the smallest percentage increase (1.5 percent), translating to an increase of almost $35 million.
• Grant funding for the Children’s Health Insurance Program, a mandatory program, increased by large amounts in some states and decreased by sizable amounts in others, relative to fiscal 2012. New Mexico, for instance, experienced a program funding cut of almost $98 million, while Vermont had an increase of over $13 million (a 38 percent decrease and a 218 percent increase from fiscal 2012 levels, respectively).
• Funding for Medicaid administration and vendor payments, which is also classified as mandatory spending, was another area where some states experienced increases while others experienced decreases. While 36 states’ Medicaid administration funding increased relative to fiscal 2012 (led by Vermont, whose funding increased by over 600 percent), 15 states’ funding decreased. These declines ranged from less than 1 percent in Georgia to 37 percent, or almost $40 million, in Maine. (Of these 15 states experiencing funding decreases for Medicaid administration, 10 experienced grant funding increases between fiscal 2011 and fiscal 2012.) Grant funding for Medicaid vendor payments also exhibited variation. At one end of the spectrum, Idaho’s funding increased almost 16 percent ($173 million), while at the other end, Washington state’s remained unchanged from fiscal 2012.

Many other programs experienced uniform funding increases. A few examples include various child nutrition and school lunch programs, the Commodity Supplemental Food Program (which provides nutritious food from the U.S. Department of Agriculture to low-income pregnant women, new mothers, infants, children, and the elderly), and the fish and wildlife hunter safety program. However, the majority of programs examined for this analysis experienced funding cuts relative to fiscal 2012.

A look at the five hardest-hit states

On net, the states experiencing the largest percentage funding cuts for federal grants in the wake of sequestration and the current CR are Louisiana, Indiana, Maine, Connecticut, and Massachusetts (Table 2). On average, those states face an estimated funding loss of 4.5 percent, or $402 million per state, relative to fiscal 2012. Those same five states, on average, experienced positive growth in federal grants over fiscal 2010–2011 and fiscal 2011–2012.

What follows is a look at the programs where the largest cuts occurred (in percentage terms, relative to fiscal 2012 funding levels) in the five heaviest-hit states:

Louisiana

• The WIC Farmers’ Market Nutrition Program, a discretionary program, was cut 26 percent (a decrease of $2,000).
• The Juvenile Accountability Block Grant, a discretionary program promoting greater accountability in the juvenile justice system, was cut 23 percent (a decline of $80,000).
• The Children’s Health Insurance Program, a mandatory program exempt from sequestration, was cut 21 percent (a decrease of just over $40 million).

Indiana

• The public works program within the Economic Development Administration (an agency that helps promote sustainable job growth and competitive, innovative regional economies), funded through discretionary spending, was cut about 36 percent (a decrease of around $1.8 million).
• The WIC Farmers’ Market Nutrition Program was cut 26 percent (a decline of around $67,000).
• The Juvenile Accountability Block Grant was cut 23 percent (a decrease of just under $105,000).

Maine

• Medicaid administration, a mandatory program, was cut about 37 percent (a decrease of about $40 million).
• The public works program within the Economic Development Administration was cut about 36 percent (a decline of just under $1 million).
• The WIC Farmers’ Market Nutrition Program was cut 26 percent (a decrease of around $20,000).

Connecticut

• The public works program within the Economic Development Administration was cut about 36 percent (a decrease of $985,000).
• The WIC Farmers’ Market Nutrition Program was cut 26 percent (a decline of just under $84,000).
• The Juvenile Accountability Block Grant was cut 23 percent (a decrease of just over $65,000).

Massachusetts

• The public works program within the Economic Development Administration was cut about 36 percent (a decline of $925,000).
• The WIC Farmers’ Market Nutrition Program was cut 26 percent (a decrease of $114,000).
• The Juvenile Accountability Block Grant was cut 23 percent (a decline of $95,000).

Conclusion

States rely on grants from the federal government to help with the efficient provision of necessary services. However, federal spending cuts are hitting many states hard, and states were already hurting before this latest round of cuts. Harris and Shadunsky (2013) have documented that in contrast to prior economic recoveries, state and local governments have experienced an unprecedented decline in economic activity, with the state and local contribution to GDP remaining negative three years after the recession’s nadir. The recession’s lingering effects continue to cause budgetary problems at the state level. Though states’ revenue levels have improved recently to help fill recession-induced shortfalls, states’ revenue collection still remains about 6 percent below where it was five years ago, even as the need for state services has grown (Johnson and Leachman 2013).

In the coming months, Congress will work on appropriations bills to fund government agencies for fiscal 2014. Though current law dictates that discretionary funding levels drop to $967 billion in fiscal 2014, congressional Democrats will push to increase that cap to $1.058 trillion. As this budget battle unfolds, future grant funding for many programs hangs in the balance.

About the author

Rebecca Thiess joined the Economic Policy Institute in 2010 as a federal budget policy analyst. Her areas of research include federal budget and tax policy, retirement security, and public investment. She has a master’s degree in public policy from Duke University and a B.A. in urban and environmental policy from Occidental College.

Endnotes

1. In this analysis, “states” refers to the 50 states plus the District of Columbia.

2. A continuing resolution is passed by Congress to fund government agencies in the event that a formal appropriations bill is not passed into law. To prevent the interruption of government services, Congress can pass a continuing resolution to fund agencies until the resolution expires. The current continuing resolution funding government for the remainder of fiscal 2013 (P.L. 113-6) was passed into law on March 26, 2013. It adheres to caps on discretionary spending enacted under the Budget Control Act of 2011.

3.  Along with creating the Joint Select Committee on Deficit Reduction, the BCA also put into place discretionary spending caps through fiscal 2021. Instead of automatic, proportional cuts to discretionary programs—as are occurring with the 2013 implementation of sequestration—in future years the congressional appropriations committees must decide how to fund discretionary programs (both defense and nondefense), taking into account the levels set by these funding caps.

4. This analysis relies on Federal Funds Information for States (FFIS) data. One FFIS dataset details state-level impacts of sequestration on grants from the federal government, while a more recent dataset details state grant funding in the wake of the March 26 passage of the continuing resolution funding the government through fiscal 2013. This paper looks at the impact of sequestration relative to the continuing resolution in place when sequestration took effect to demonstrate what the impacts were at the point when sequestration hit. The analysis then looks at impacts on state grants after the passage of the most recent continuing resolution in order to provide the most up-to-date analysis of how recent federal fiscal policies have affected state budgets for the current fiscal year. In this part of the analysis, funding levels are compared with fiscal 2012 funding due to data availability.

5. Due to the exemption of Medicaid (see endnote 6), grants to states are less negatively affected than they would be if sequestration were administered purely across-the-board. However, as this analysis demonstrates, many states will be affected by cuts to non-exempt programs.

6. Both discretionary and mandatory programs were affected by sequestration, though in regard to state grants, significantly more mandatory programs than discretionary programs were exempt. Exempted mandatory programs include Medicaid, the Children’s Health Insurance Program, Social Security, Supplemental Security Income (SSI), and the Supplemental Nutrition Assistance Program (SNAP).

7. The cuts are presented as a share of 2007 GSP because states’ economic situations were likely more volatile during and immediately after the recession.

References

Bureau of Economic Analysis (U.S. Department of Commerce). Regional Economic Accounts. Various years. “Real Gross Domestic Product by State (millions of chained 2005 dollars), 1997-2011.” http://www.bea.gov/itable/index_error_regional.cfm.

Congressional Budget Office (CBO). 2013. Federal Grants to State and Local Governments. http://www.cbo.gov/publication/43967

Federal Funds Information for States (FFIS). Various years. Grants Database [available via subscription]. http://www.ffis.org/database

Harris, Benjamin, and Yuri Shadunsky. 2013. State and Local Governments in Economic Recoveries: This Recovery is Different. State & Local Finance Initiative, Tax Policy Center. http://taxpolicycenter.org/UploadedPDF/412807-State-and-Local-Governments-and-Recessions.pdf

Johnson, Nicholas, and Michael Leachman. 2013. Four Big Threats to State Finances Could Undermine Future U.S. Prosperity. Center on Budget and Policy Priorities. http://www.cbpp.org/cms/index.cfm?fa=view&id=3903

Kogan, Richard. 2013. The Pending Automatic Budget Cuts: How the Two “Sequestrations” Would Work. Center on Budget and Policy Priorities. http://www.cbpp.org/cms/?fa=view&id=3910

Office of Management and Budget (OMB). 2012. Analytical Perspectives, Budget of the United States Government, Fiscal Year 2013. http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/spec.pdf

Pew Center on the States. 2012. The Impact of the Fiscal Cliff on the States. Pew Center on the States, Fiscal Federalism Initiative. http://www.pewstates.org/uploadedFiles/PCS_Assets/2012/Pew_fiscal_cliff_report.pdf

But even ignoring the macroeconomic damage wrought by sequestration, this across-the-board meat cleaver approach to cutting spending is often fiscally imprudent even on a programmatic level.

For instance, the Office of Management and Budget estimated that the Internal Revenue Service tax enforcement department would see $436 million dollars of budget authority sequestered in fiscal 2013. (This estimate predates the lame duck deal’s two-month delay, although the fiscal 2014 cut would be larger.) But by all estimates, marginal increases in funding for tax enforcement pay for themselves multiple times over. In fiscal 2012, IRS enforcement raised $50.2 billion in revenue, or $2.3 million per enforcement agent. Former George W. Bush administration IRS Commissioner Mark Everson estimated that every additional dollar spent would return $4 in revenue, for $3 in deficit reduction (Sawickey et. al 2005). That would imply that the full fiscal 2013 cut could add $1.3 billion to the budget deficit.

In a similar vein, the U.S. Green Building Council highlights how sequestration’s across-the-board design will cut energy efficiency programs that save the federal government operating expenses, notably the energy efficiency programs of the Department of Defense and General Services Administration. And the government may end up having to pay penalties to suppliers if the sequester forces it to cancel contracts.

Blindly cutting government spending in a depressed economy is not fiscally responsible: You end up trading smaller structural budget deficits for bigger cyclical budget deficits, and a smaller economy makes the fiscal outlook relatively less sustainable. Similarly, cutting government programs that pay for themselves—simply because they are government programs—is not fiscally responsible.

That sequestration is in many ways counterproductive to long-run fiscal responsibility and will cause substantial disruptions to government operations and services is not an accident. Reports suggest some Congressional Republicans have concluded sequestration taking effect would best minimize the need for future tax increases—drowning government in Grover Norquist’s proverbial bathtub. As summarized by Ezra Klein, “The GOP’s top priority is resisting further tax increases, and given President Obama’s insistence on new revenues in any sequester replacement, their position on the sequester is exactly what you’d expect if you held that principle as inviolable.” This strategy echoes Republicans on the “Super Committee” refusing to replace the sequester with anything including a penny of revenue, as well as Speaker Boehner’s (R-OH) refusal to use tax loophole closers to offset any of the sequester. Indeed, Boehner’s oft-stated position that “Spending is the problem, and spending cuts are the solution,” encapsulates that this is explicitly not about deficit reduction.

The Budget Control Act and its sequester were never about fiscal responsibility—indeed its inception stemmed from the mind-boggling fiscally irresponsible act of hijacking the debt ceiling and playing chicken with a self-induced debt crisis.

If sequestration takes effect, it will be because congressional Republicans put draconian spending cuts in play, and have subsequently refused to replace those cuts with more sensible deficit reduction. And should sequestration take effect, this would not be an isolated case of economic policy malpractice: Congressional Republicans have consistently hamstrung efforts that economists overwhelmingly agree would have meaningfully helped lower the unemployment rate and instead advanced policies projected to decelerate near-term growth.

My colleague Josh Bivens and I recently chronicled at length the numerous, varying ways Congressional Republicans have deliberately obstructed a stronger economic recovery over the past four years. 1 This economic and budgetary obstructionism, in turn, has been a considerable factor explaining why U.S. economic growth has decelerated since mid-2010 and is currently far too slow to push the economy back to full health in the next few years, already more than five years after the start of the Great Recession.

What follows is a not-so-quick history of how we got to this week’s deadline.

The Budget Control Act (BCA) of 2011—which spawned the sequester—was forced into existence by congressional Republicans refusing to undertake the customarily pro forma increase in the nation’s statutory debt ceiling. Instead, they held the debt ceiling increase hostage to deep spending cuts—over and above the $500 billion in discretionary spending cuts they had already won by filibustering a Senate omnibus spending bill and threatening a government shutdown. The Washington Post has detailed at great length that this ransoming of the debt ceiling was premeditated rather than a spontaneous act of beltway dysfunction.

The GOP’s policy advancement of deep government spending cuts in the face of severe economic weakness threatens to slow economic activity so much that falling tax revenues and increased automatic safety net spending will translate into higher debt ratios than would have existed before the cuts. In short, such cuts are even fiscally, not just economically, counterproductive.

During the debt ceiling negotiations in the summer of 2011, the Obama administration regrettably acquiesced to the GOP’s demand that every dollar increase in the debt ceiling be matched dollar-for-dollar with spending cuts (a demand widely referred to as the “Boehner rule”). This “Boehner Rule” was codified in law with the 11^th hour enactment of the BCA on Aug. 2 (the last day Treasury could avoid defaulting).

The BCA had two phases. The first phase was almost entirely comprised of discretionary spending cuts and caps, and was essentially accompanied with a $900 billion increase in the statutory debt ceiling (equal to policy savings plus reduced debt service). The default for the remaining $1.2 trillion increase in the debt ceiling—enough to prevent another showdown until after the presidential election—was $984 billion in automatic sequestration cuts (or $1.2 trillion in savings with interest).

This automatic enforcement mechanism was designed to force the Joint Select Committee on Deficit Reduction (JSC, better known as the “Super Committee,” another creation of the BCA) to compromise on more sensible methods of deficit reduction. The form of the cuts—across-the-board, evenly split between defense and non-exempt domestic spending—was meant to be anathema to both political parties. Other parts of their design were also intentionally poorly constructed; the reductions in budget authority were evenly split in nominal dollars across nine fiscal years, so that the cuts actually shrink as a share of the economy. This front-loading of cuts into today’s weak economy is particularly perverse, and means that agencies have less time to adjust to new, lower funding levels. Further, by demanding austerity that was entirely comprised of spending cuts, the BCA maximized the economic harm posed by sequestration per year (a dollar of government spending cuts currently inflicts four-to-seven times the damage of a dollar of revenue). Despite all this, the Super Committee failed because GOP members refused to agree to the inclusion of even a penny of revenue to improve deficit reduction’s economic, programmatic, and distributional effects.

But before one gets too deep into the weeds, one should realize that real blame for the sequester can be laid at the feet of the GOP House leadership, who used the unprecedented threat of default on the nation’s debt to force $2.1 trillion of spending cuts. Period. Now the spending cuts that they demanded are poised to do substantial harm to our already depressed economy.

Should sequestration take effect for the remainder of the year, we estimate it will slow growth by an additional 0.6 percentage points and reduce employment by 660,000 jobs in 2013. That’s down slightly from 0.9 percentage points and some from 0.7 percentage points from growth and roughly 830,000 job losses we were forecasting before the lame-duck deal’s two-month punt. Our estimates are largely in line with those from Moody’s Analytics and the Congressional Budget Office (CBO), among others.

Some pundits have proffered that the cuts will not prove as bad as hyped, in part because the remaining $85 billion reduction in budget authority (BA) for fiscal 2013 only translates to $42 billion in reduced outlays. (Outlays lag somewhat behind the authority to spend money, and outlays more directly affect economic activity—the impacts cited above are based on outlays.) But the projected outlay reduction jumps to $89 billion in fiscal 2014 because the two-month delay disappears and outlays fall because of reduced BA in both fiscal 2013 and fiscal 2014. We project the economic drag from sequestration rises to 0.8 percentage points from real GDP growth and 910,000 job losses in calendar year 2014. In short, “good news” in the form of outlays lagging authority in 2013 just means worse news for next year.

It’s worth noting that these mounting drags would reinforce a marked trend deceleration in economic growth since mid-2010, which has already been exacerbated by the first phase of the BCA: We estimated that the BCA discretionary spending caps would shave 0.3 percentage points from real GDP growth in 2012 and further ratcheting down of the caps would reduce real GDP growth by 0.4 percentage points in 2013, relative to pre-BCA law. All told, the BCA accounted for roughly one-third of the fiscal drag for 2013 posed by the “fiscal cliff” ahead of the lame duck deal. And as underscored by the looming sequestration cuts, the lame-duck deal didn’t resolve the fundamental “fiscal cliff” challenge, which was overly rapid deficit reduction.

Perhaps most perversely, sequestration taking effect would actually increase the public debt-to-GDP ratio (the most commonly used metric of fiscal health). CBO’s February 2013 baseline—which assumes sequestration takes effect—projects public debt at $12.229 trillion by the end of fiscal 2013, for a 76.3 percent debt-to-GDP ratio relative to a $16.034 trillion economy. Assuming a fiscal multiplier of 1.4, meaning a dollar of government spending generates $1.4 in economic activity (and which is robust to a range of best estimates), repealing the BCA’s $42 billion reduction in fiscal 2013 outlays would increase GDP by $58 billion. And for every dollar the U.S. economy moves back toward potential output, the cyclical budget deficit shrinks by $0.37 (as tax receipts rise and spending on automatic stabilizers falls). Thus repealing $42 billion sticker price of sequestration would claw back $22 billion from the cyclical deficit, for an effective cost of $20 billion. And on net, adding $20 billion to public debt while boosting GDP by $58 billion would lower the debt-to-GDP ratio from 76.3 percent to 76.1 percent.

Beyond impeding near-term recovery and worsening the fiscal outlook, sequestration and the BCA at large threaten long-term growth in two ways. By delaying the return to full employment, the BCA will leave more productive resources to atrophy, exacerbating exceptionally inefficient economic scarring that is already lowering estimates of the U.S. economy’s long-run potential (see Bivens, Fieldhouse, and Shierholz 2013). And because the relatively small non-security discretionary budget—which is half comprised of public investment, totaling 90 percent of nondefense public investment—took the brunt of spending cuts, the legislation is starving the U.S. economy of a key driver of long-run growth.

When the BCA was enacted, my colleague Ethan Pollack and I coauthored a report “Debt ceiling deal threatens deep job losses and lower long-run economic growth” which highlighted the above mentioned economic risks posed by premature austerity and defunding public investment. As pending sequestration spending cuts loom increasingly likely, our analysis from 2011 remains fundamentally unchanged: No economic good could possibly come of the BCA’s discretionary spending caps and sequestration cuts.

Worse, U.S. policymakers are refusing to heed ample evidence since August 2011 cautioning against austerity: Premature austerity subsequently pushed the U.K. back into recession, and BCA discretionary caps have coincided with (and almost certainly contributed to) the trend of U.S. economic growth slowing so much that the economy is moving away from full recovery instead of even treading water. Diametrically opposed to this evidence-based policy analysis, some congressional Republicans have calculated that they should allow sequestration to occur because it maximizes the spending cuts they can extract and, relatedly, minimizes the revenue share of long-term deficit reduction. Wittingly or unwittingly, that corresponds with maximizing the economic sabotage Congress can inflict, short of, say, forcing a self-induced sovereign debt crisis. Their calculus is a damning indictment of our political system’s failure to uphold the social contract that had prevailed since the Great Depression that the federal government would target full employment and promote the general welfare of its citizens.

1. Specifically, they have objectively weakened the American Recovery and Reinvestment Act (ARRA), repeatedly filibustered routine extensions of emergency unemployment benefits, blocked aid to state governments, filibustered infrastructure investment, used extreme legislative vehicles like refusing to follow precedent on the typically pro forma votes to raise the debt ceiling to extract more economically damaging government spending cuts, blocked passage of a majority of the American Jobs Act (AJA), demanded counterproductive offsets to fiscal stimulus, and attacked the Federal Reserve’s expansion of the monetary base and other policy responses intended to lower unemployment.

This paper provides an overview of the state of the U.S. economy—with a particular focus on the labor market—five years after the onset of the Great Recession. It also analyzes why the U.S. economy has failed to fully recover and argues for much more ambitious, sustained federal fiscal support to achieve full employment.

The paper begins by outlining the extent of the economic damage inflicted by the Great Recession and explaining that the anemic nature of the recovery stems from a lack of demand for goods and services. Next, the paper draws upon contemporary, historical, and international lessons to argue that policy inaction—or worse, contractionary fiscal policy—is the greatest risk to full recovery. It then explores how the recent “fiscal cliff” debate and subsequent lame-duck budget deal signal that government action to spur recovery is unlikely, and that contractionary fiscal policy will actually undermine recovery in the coming years. Following this, the paper analyzes what it would take to move the economy back to health—and argues that the alternative of continued economic stagnation is hugely wasteful and will exacerbate projected medium- and long-term budget deficits that have been a focal point of public debate in recent years.

Key findings include:

• The economy, particularly the labor market, remains far from normal. At the end of 2012, national output was roughly $1 trillion below what it could have been if the economy were at full employment. Furthermore, as of December 2012, 9.1 million jobs needed to be created to restore prerecession labor market health.
• The gap between actual and potential economic output and labor market health is almost entirely a function of deficient economic demand—households, businesses, and governments are not spending enough to keep all workers and productive capacity employed. This diagnosis is the only one consistent with the economic evidence—particularly the failure of long-term interest rates and measures of core inflation to rise even as federal budget deficits have increased sharply.
• The large rise in federal budget deficits beginning in 2008 is mainly a symptom of the weak economy, and has actually supported and sustained the return to economic growth. In fact, a swifter return to full employment will require policymakers to use larger deficits in the near term to finance job-creation measures.
• Too many near- and medium-term economic forecasts assume a return to full employment relatively quickly. It is a deeply risky economic strategy to rely on these forecasts, which have consistently proved overly optimistic, instead of ensuring a return to full employment through policy measures (particularly fiscal policy).
• The debate about the proper resolution of the “fiscal cliff” largely ignored the danger inherent in failing to spur near-term economic growth to ensure full recovery. It instead fixated on the theoretical danger posed by projected medium- and long-term budget deficits and on ensuring just enough growth to avoid another recession. This is exactly the wrong policymaking focus.
• Even with the lame-duck budget deal, the U.S. economy is projected to remain depressed, with GDP between $941 billion and over $1.0 trillion below full employment output at the end of 2013 (depending on how Congress handles the remainder of scheduled sequestration cuts). Furthermore, real growth rates in 2013 are projected to slow below 2.0 percent, to the point of renewed labor market deterioration.
• Guaranteeing a return to full employment by the end of 2015 would require policymakers to fund economic stimulus of roughly an additional $650 billion in 2013 and somewhere in the range of $1.5 trillion to $2.2 trillion over the next three years. That these amounts are so far outside the current bounds of political viability indicates how divorced from economic reality the fiscal policymaking debate has become.

Five years from its beginning, Great Recession’s shadow remains

The economy has gone five years since the beginning of the Great Recession without remotely approaching a full recovery. The recession inflicted enormous, long-lasting economic damage, particularly on the labor market and on the living standards of low- and moderate-income Americans. However, at the root of this damage is a shortfall in households’ and businesses’ lack of demand for goods and services—an eminently solvable problem.

The extent of the economic damage inflicted by the Great Recession

Figure A

While there are many ways to document just how abnormal today’s economy is, arguably the best summary measure is the “jobs gap”—the number of jobs necessary to restore prerecession labor market health. Even five years since the beginning of the Great Recession, the jobs gap remains dismayingly large, at 9.1 million jobs as of December 2012, as shown in Figure A. This number combines the net 3.4 million jobs lost between December 2007 and December 2012 and the 5.8 million jobs that should have been created during this time to absorb new potential labor market entrants. (As a rule of thumb, slightly more than 100,000 new jobs are needed every month to absorb population and labor force growth and prevent the unemployment rate from rising.) Filling the jobs gap would take more than three years of annual economic growth averaging at least 5 percent—growth rates that will not materialize without an abrupt change in fiscal policy. If the average monthly gains of 181,000 jobs throughout 2012 persist, this jobs gap would not close until 2019. In short, five years after the onset of the Great Recession, full economic recovery still remains years and years away.

Figure B

Another symptom of the Great Recession’s lingering impact is the elevated unemployment rate. As previously mentioned, it stood at 7.8 percent in December 2012, more than three percentage points higher than the 4.6 percent average of 2006 and 2007. That is also higher than the peak unemployment rate following the recession of 2001, and equal to the peak rate following the recession of 1990–1991. Though some groups have been hit harder than others since the beginning of the Great Recession, unemployment is significantly elevated across the board—among all age groups, both genders, all racial and ethnic groups, and for workers in all major industries, occupations, and education groups. To help illustrate this point, Figure B presents the unemployment rate in 2007 and 2012 by education category. It shows that unemployment is lower for workers with higher levels of education, but this is always true. Strikingly, however, workers with a college degree or more still have unemployment rates roughly twice as high as before the recession began—approximately the same relative increase experienced by workers with less education. The figure underscores that elevated unemployment is not restricted to certain types of workers; the burst of the housing bubble caused a broad-based drop in demand for goods and services (as will be discussed in more detail shortly), in turn causing a broad-based drop in demand for workers. Only a small portion of that decline has been restored in the three-and-a-half years since the official end of the Great Recession, and unemployment remains extremely elevated across the board.

Furthermore, the unemployment rate currently understates weakness in the labor market. This is because so many people have dropped out of—or never entered—the labor market due to weak employment opportunities, and are thus not counted among the unemployed. The labor force participation rate—the share of the working-age population either employed or looking for work—dropped from 66.0 percent when the Great Recession began in December 2007 to 63.6 percent in December 2012. This decline represents nearly 6 million fewer workers in the labor force. It is important to note that some of this drop is due to structural changes that would have occurred even without the Great Recession, notably baby boomers entering retirement and the increasing college enrollment of young people. However, roughly two-thirds of this drop is due to the lack of job opportunities (Shierholz 2012). Thus, the pool of “missing workers”—workers who would currently be in the labor force if job opportunities were strong—is nearly 4 million. If these workers were in the labor force and were unemployed, the unemployment rate would currently be almost 10.0 percent.

With the labor force not growing “normally,” arguably a better gauge than the unemployment rate for assessing recent labor market trends is the employment-to-population ratio (EPOP) of “prime-age” workers, which is simply the share of the age 25–54 population with a job. (Restricting to prime-age workers provides more certainty that any trends we see are driven by demand for workers and not previously mentioned structural factors such as retiring baby boomers or increased college enrollment.) The EPOP for prime-age workers is shown in Figure C. It depicts a dramatic plunge from about 80 percent near the start of the recession to under 75 percent in the fourth quarter of 2009. It made essentially no progress for the next two years. By December 2012, it had improved modestly to 75.9 percent, only slightly above its post-recession lows. This demonstrates that the vast majority of the improvement in the unemployment rate from its peak of 10.0 percent in October 2009 to 7.8 percent in December 2012 is due to people dropping out of (or not entering) the labor force—not to a larger share of potential workers finding employment. Such improvement in the unemployment rate is clearly not satisfactory.

Figure C

Widespread employment declines since the beginning of the Great Recession, along with both underemployment and the strong downward pressure that persistent high unemployment exerts on wages, have led to massive drops in household income. Figure D shows the inflation-adjusted median income of working-age households (those where the household head is under age 65) from 2000 through 2011. Between 2007 and 2011 alone, the typical income of working-age households dropped by $5,715, or 9.3 percent. This figure also reveals that the United States has already experienced more than a “lost decade.” The business cycle expansion from 2001 to 2007 was the weakest on record for job growth and was the first business cycle on record where median household incomes did not grow. Indeed, income of the typical working-age household dropped by $2,180 between 2000 and 2007. All told, income of the typical working-age household in 2011 was nearly $8,000 (12.4 percent) lower than in 2000—and had fallen below inflation-adjusted 1994 levels.

Figure D

Unfortunately, this trend of declining typical incomes is likely to continue for the foreseeable future. In EPI’s recently released The State of Working America, 12th Edition (Mishel et al. 2012), a projection based on the past statistical relationship between unemployment and income growth of the middle fifth of families, and on macroeconomic forecasts of unemployment, shows that a full two decades will almost certainly pass from the year 2000 without a noticeable increase in family incomes near the middle of the income distribution.2 This is illustrated in Figure E, which depicts the decline in average real family income for the middle fifth of the income distribution between 2000 and 2010. The dotted lines are the result of an exercise that models the relationship between income growth and the unemployment rate between 1948 and 2010, and then uses the findings to predict the trajectory of incomes if unemployment projections for the next several years actually come to pass. Using the Congressional Budget Office’s (CBO) unemployment projections, average income for families in the middle income fifth in 2018 will be 10.9 percent below its 2000 level. Using Moody’s Analytics unemployment rate projections, which are somewhat more optimistic, average incomes of families in the middle income fifth will be 6.5 percent lower in 2018 than in 2000. This is an unmitigated economic disaster. Stagnating or declining inflation-adjusted typical incomes in the context of rising real national income directly implies greater income inequality. Persistent, sizable slack in the labor market has exacerbated income inequality—and will continue to do so.

Figure E

Root of today’s economic woes remains demand shortfall

Despite the troublesome trends just discussed, there is some good news: The U.S. economy’s present predicament stems from a collapse in households’ and businesses’ demand for goods and services, not a collapse in our ability to supply these goods and services. Essentially, the burst of the housing bubble erased trillions of dollars of wealth from household balance sheets and left homebuilders with a massive unsold inventory. The pullback in consumer spending (households spent less because they were much less wealthy) and construction (companies stopped building, as even their existing inventory could not be sold) then cascaded throughout the rest of the economy. Businesses stopped investing in new factories; since they were producing more than they could sell with existing capacity, they did not need to invest in increased capacity. Lastly, the chaos in financial markets sparked by the bursting bubble provided an extra spur to businesses and households to hoard liquid assets at the expense of consumption. It also impeded plans by those rare businesses and households that wanted to expand spending by denying them needed credit. In short, the burst housing bubble led to sharp reductions in private-sector spending by households and businesses.

That the Great Recession was caused by this shock to demand is important to acknowledge. American workers did not lose their skills at the onset of the recession in December 2007. American factories did not become obsolete that month, nor did American managers forget how to efficiently organize production. In fact, there is no evidence of any present disruption in our ability to supply goods and services, but only in the private sector’s capacity to demand them.3 In short, the root of the United States’ current economic woes is an ongoing and scarcely improving shortfall in aggregate demand relative to the supply of productive resources. Indeed, this shortfall is why Paul Krugman has labeled the present situation the “Lesser Depression” (Krugman 2011).

Why policy action is necessary to ensure a full recovery

Given that a demand shortfall is central to the economic damage inflicted by the Great Recession, ambitious policy action is necessary to fill this shortfall and ensure a full recovery. Lessons from the U.S. response thus far to the Great Recession, historical lessons from the 1980s and 1930s, and lessons from Europe’s and Japan’s economic troubles buttress the case for sustained, large-scale government action to stimulate demand and accelerate growth.

Lessons from the U.S. response thus far to the Great Recession

The U.S. economy’s failure to rapidly make up ground once the trough of the Great Recession was reached is too often treated as a vexing puzzle, and has inspired many (mostly ill-conceived) theories as to just what is holding back the U.S. economy from reaching its pre–Great Recession potential. In fact, the question is not Why has the economy failed to reach a full recovery yet? but, Why would this full recovery be expected at all, given the policy course we have charted?

After all, there is a large economics literature on the unique danger posed by steep downturns that persist even as a nation’s central bank maximizes the economic support it can provide through conventional means (this generally entails lowering the short-term “policy” interest rates that it essentially controls). In the economics jargon, this is generally referred to as economies being mired in a “liquidity trap,” or stuck against the “zero lower bound” of nominal interest rates. And the research on what to do in such situations is clear: Policymakers should pull every macroeconomic policy lever that can increase aggregate demand as hard as they can. This means targeting larger budget deficits to finance job-creating investments and safety net spending, undertaking unconventional monetary policy measures such as announcing higher inflation targets and aggressively buying long-term debt (i.e., buying Treasuries or private-sector asset-backed securities, thereby lowering long-term interest rates), and ensuring that the nation’s currency is not being artificially propped up in a way that widens the trade deficit.

While aspects of the Great Recession and global economic slump have made this sort of demand stabilization harder than usual, the most obvious policy failure is that the most effective tool for stabilization—fiscal support provided through increased government spending, investments, and transfer payments—was prematurely abandoned (Bivens 2011).4

Initially, large automatic increases in federal budget deficits—partially stemming from increased federal spending on safety net programs, such as unemployment insurance, Medicaid, and food stamps—blunted the negative shock from the burst of the housing bubble. In addition, legislated actions such as the Economic Stimulus Act of 2008 (signed by President George W. Bush) and the American Recovery and Reinvestment Act (ARRA) of 2009 (signed by President Barack Obama) arrested the economic free-fall. In late 2009 and early 2010, ARRA provided an effective counterweight to reduced spending by households and businesses, albeit insufficient to spur full recovery. And in conjunction with the Federal Reserve’s aggressive monetary policy actions, expansionary federal fiscal policy is widely credited with ending the Great Recession in mid-2009 and thereafter sustaining a tepid recovery (Blinder and Zandi 2010).

Indeed, during the first year of the recovery (from mid-2009 to mid-2010), the economy’s growth rate (as measured by growth in per capita GDP) was actually slightly faster than in the previous two recoveries, as shown in Figure F. These recoveries from the 1990–1991 and 2001 recessions—unlike those in the 1960s, 1970s, and 1980s—were also characterized by the bursting of asset market bubbles and resulting financial distress. Federal fiscal support in this first year of the current recovery added roughly 1.3 percentage points to GDP growth.

Figure F

However, between the middle of 2010 and the third quarter of 2012, federal fiscal policy turned contractionary, subtracting roughly 0.5 percentage points, on average, from growth rates. And after this first year of recovery, the economy’s performance began to seriously lag: Annualized real GDP growth decelerated to 1.5 percent for 2012 and 2.0 percent for 2011, down from 2.4 percent in 2010 and 2.7 percent in the last six months of 2009 (the first half-year of official recovery).5 In the three-and-a-half years since the recession officially ended, the economy has grown at an average annualized rate of just 2.1 percent. As a rule of thumb, real GDP growth between 2.0 percent and 2.5 percent is needed just to keep the labor market treading water, so growth above this range is what policymakers must target to ameliorate the jobs crisis.

A driving force behind this sluggish growth following the fade of ARRA’s economic boost is public-sector austerity, particularly on the part of state and local governments. Unlike the federal government, most states are constrained by balanced budget amendments that forced spending cuts and tax increases as the recession eroded tax collections and increased demands on state safety net spending. Falling state and local government consumption expenditures and gross investment dragged at overall real GDP growth rates for 12 of the 13 quarters up through the end of 2012. As previously noted, since mid-2010, federal fiscal policy has been slightly contractionary, failing to counter the sharp contractionary effect of state and local fiscal policy. Consequently, the net economic impact of federal, state, and local budget policy has dragged on economic growth since the fourth quarter of 2009 (Pollack 2011). Without state and local budget austerity, employment would be roughly 2.3 million jobs higher today (with roughly half these jobs coming from the private sector). These jobs would be enough to close one-fourth of the “jobs gap” depicted in Figure A (Shierholz and Bivens 2012).

It is important to note, however, that while state-level austerity has been a net drag on the economy, states that received more fiscal aid from the federal government had better outcomes—showing again that spending cutbacks in the face of a depressed economy worsen the damage. (See Wilson 2011 and Chodorow-Reich et al. 2012 for particularly good analyses of the cross-state effects of fiscal expansion.)

The trajectory of economic activity in the aftermath of the Great Recession indicates that the damage inflicted by the recession is historically deep and broad, and that policymakers should have proposed solutions matching the scale of the crisis. But it is important to realize that when policy responses were closer to the scale of the problem—particularly when fiscal policy substantially boosted economic growth rather than dragging on it—the recovery proceeded more rapidly. Thus, the disappointing performance over the past two-and-a-half years is no puzzle that needs explanation; rather, it is exactly what textbook macroeconomics predicts. In short, in situations such as the aftermath of the Great Recession, failing to ensure a full economic recovery before withdrawing policy support can counterproductively lead to entire decades of lost income growth and avertable depression. To avoid this fate, sustained, large-scale policy action to stimulate demand and boost economic growth should be policymakers’ foremost priority.

As explained in the following subsections, lessons drawn from U.S. economic history and from recent downturns in Japan and Europe further highlight the risks to prematurely withdrawing economic support before full recovery is achieved.

Historical lessons for why policy action is needed

The U.S. recovery from the 1981–1982 recession demonstrates that economic growth rapid enough to reliably pull down unemployment is possible, so long as policymakers strive to boost demand. In the three-and-a-half years following the recession that ended in the last quarter of 1982, the economy grew at an average annualized rate of 5.4 percent—about two-and-a-half times faster than in the current recovery. The explanation is simple: Policymakers aggressively used both fiscal and monetary policy to spur growth. On the fiscal side, government consumption and investment spending rose 18.9 percent over the first 14 quarters of recovery following the 1981–1982 recession, while such spending fell 5 percent in the first 14 quarters following the Great Recession. Had government consumption and investment spending in the current recovery matched the trajectory after the 1981–1982 recession, growth since the recession’s end in 2009 would have averaged 3.7 percent instead of 2.1 percent.6

On the monetary side, the Federal Reserve was able to pull down short-term policy interest rates by nearly 11 percentage points between the beginning of the 1981–1982 recession and the first three-and-a-half years of the recovery, including a reduction of more than two percentage points between the end of the recession and the first three-and-a-half years of recovery. In contrast, the Federal Reserve only had room to cut these rates by four percentage points between the beginning of the Great Recession and the first three-and-a-half years of the recovery. Furthermore, it has been impossible to lower these rates since the end of the recession, as they are bound by the zero nominal interest rate.

It is clearly the case that both the character of the Great Recession (it was driven by an asset bubble bursting) as well as its severity (it was the largest shock to private-sector spending since the Great Depression) have made it more difficult to counteract with macroeconomic policy—particularly monetary policy, which has become the economic stabilizer of choice for policymakers over the last few decades. Yet this is no excuse for not trying to use macroeconomic policy as aggressively as possible to spur demand. For when demand is boosted by policy, past experience shows that rapid recovery and restoration of labor market health is possible.

A lesson from earlier in U.S. economic history reinforces this point, albeit by serving as a cautionary example. In the second half of 2010—as the unemployment rate remained close to 10 percent, the boost from ARRA was fading, and the current law budget trajectory implied steep fiscal contraction in 2011—a number of economic observers began raising concerns about repeating the “Mistake of 1937.” This refers to the decision in 1937 to begin ramping down fiscal and monetary support, as policymakers were confident that a durable recovery from the Great Depression was ensured. Due to spending reductions and tax increases, the federal budget swung from a deficit of 3.8 percent of GDP in 1936 to a small surplus in 1937. Combined with a tightening of monetary policy, this led to a contraction of 3.4 percent of real GDP in 1938. This is a steeper contraction than registered even in the worst year of the recent Great Recession, and is the second-worst post-1932 year on record (the worst post-1932 year being the very rapid but very steep contraction in 1946 associated with the drawdown of defense spending after World War II).

Luckily, the “Mistake of 2011” never happened, largely because the Obama administration agreed to delay one of its highest policy priorities—ending the upper-income Bush-era tax cuts—in exchange for House Republicans extending some fiscal support measures for 2011 and 2012. Economic growth, although slow, would have been weaker without the continuation of emergency unemployment benefits and the two-percentage-point cut in employee payroll taxes contained in this deal. We project these measures boosted real GDP growth by 1.3 percentage points by the end of 2012, increasing employment by roughly 1.5 million jobs (Bivens and Fieldhouse 2012a). Without this fiscal support, trend growth would almost certainly have decelerated below 1 percent, meaning the labor market would have lost ground instead of roughly holding steady.

Yet at the beginning of 2013, with current law again calling for steep fiscal contraction in the face of still-elevated unemployment (as will be discussed in greater detail shortly), the lessons of 1937 should be heeded: Periods of severe economic weakness need to be fought by policymakers until full health is restored. This full health will likely be signaled by the Federal Reserve raising interest rates to cool down demand-side inflationary pressures. The U.S. economy remains far from this point, as the Federal Reserve projects inflation will remain at or below its target level for price stability for the foreseeable future.

International lessons for why policy action is needed

International evidence also points to risks from prematurely abandoning the fight against economic downturns. Japan fell into a steep recession in the early 1990s as a result of the bursting of stock market and housing price bubbles. While the recession was painful, recovery had begun by 1994. Over the next three years the economy nearly reached its underlying growth potential, with expansion being led by private consumption and investment. In late 1996, however, the Japanese government began steep cuts to public investment. By the end of 1997, the economy was in a much more serious recession than in even the early 1990s, and the Japanese economy did not sustain acceptable growth rates again until the 2002–2007 period before the Great Recession. According to a close observer of the Japanese economy:

“[T]hese recoveries in Japan in the 1990s…could have been sustainable, but were cut off by macroeconomic policy mistakes. … Whether in Japan in the 1990s or in the U.S. in 2008-2010, heated discussions take place as though the short-run effects of fiscal policy were in dispute. They should not be. Fiscal policy works when it is tried. … This is conclusively demonstrated in Japan.” (Posen 2010)

This claim that fiscal policy works when tried is buttressed by international evidence. Figure G shows the relationship in developed countries between changes in government spending (a crude proxy for how aggressively countries have fought the global downturn with activist fiscal policy) and economic performance. The relationship is clear—countries that have resisted austerity have performed better.

Figure G

We should be clear that while federal policymakers in the United States have enacted some austerity—much of which had yet to take effect as of the fourth quarter of 2012—the United States has so far avoided the extraordinarily damaging austerity embraced in many other countries. This can be seen in comparisons with the eurozone countries and the United Kingdom. As Figure H shows, the recoveries, particularly in the United States and United Kingdom, looked broadly similar until mid-2010. At that time, a newly elected Conservative Party–led coalition government in the United Kingdom immediately undertook sharp fiscal austerity. The results are clear—the United Kingdom reentered recession in the fourth quarter of 2011 and, after a brief respite in the third quarter of 2012, registered a 1.2 percent annualized contraction in the fourth quarter of last year. As of the end of 2012, the U.K. economy had contracted in five of the past nine quarters.

Figure H

Of course, “not as bad as the eurozone and the United Kingdom” is far too generous a curve on which to grade U.S. federal policymakers. The appropriate policy stance is not one that allows the United States to avoid outright economic contraction, but one that rapidly pushes the economy back to full employment. This will require ambitious policy action aimed at spurring demand and accelerating growth. (See the section “What it would take to ensure a full recovery” for a discussion of the scale of policy action required.)

“Fiscal cliff” debate should have been laser-focused on full employment

On the whole, the current U.S. economic debate has failed to acknowledge the lessons previously outlined that demonstrate a clear need for large-scale policy action. This is reflected in the unproductive debate over the so-called fiscal cliff of scheduled spending cuts and tax increases that policymakers only partially mitigated during the “lame-duck” session at the end of the 112th Congress. It is also reflected in the partial resolution of the “fiscal cliff,” which entails more recovery-undermining austerity.

The unproductive nature of the “fiscal cliff” debate

Throughout the “fiscal cliff” debate, policymakers were focused on the too modest goal of avoiding a return to outright recession through fiscal tightening. At the most basic level, the “fiscal cliff” would have closed budget deficits too quickly—meaning public debt would have risen too slowly—thereby pushing the economy into an austerity-induced recession. If the scheduled budget changes had taken effect and been sustained far into 2013, they would have shaved 3.7 percentage points from real GDP growth by the end of 2013, relative to mitigating all major fiscal drags (Bivens and Fieldhouse 2012b). In addition, CBO was forecasting the economy would have shrunk an annualized 2.9 percent in the first half of the year, pushing unemployment back above 9 percent (CBO 2012c). Contrary to recent years’ misplaced but pervasive hand-wringing about rising public debt, this fear of the “fiscal cliff” implied that sizable budget deficits and debt accumulation have actually sustained growth and economic recovery, not slowed them, in recent years.

The “cliff” metaphor was a misguided framing of the actual economic challenge at hand that likely exacerbated the unproductive nature of the surrounding debate. Policymakers did not face a binary choice, as the pending fiscal restraint was composed of fully separable policies.7 But the most striking aspect of the debate was many policymakers’ failure to appreciate that the economic context surrounding the “fiscal cliff” was an economic depression being perpetuated by austerity, despite the previously described evidence counseling against forcing austerity on a depressed economy.

The budget deficit has already shrunk from 10.1 percent of GDP in fiscal 2009 to 7.0 percent of GDP in the recently ended 2012 fiscal year, and is projected to shrink to 5.3 percent of GDP in the current 2013 fiscal year (CBO 2013b). This is the most rapid rate of fiscal consolidation since the demobilization from World War II (Graham 2013). Beyond the wind-down of ARRA and even ignoring the Budget Control Act’s (BCA) sequester, since 2011 Congress has already enacted $1.5 trillion of discretionary spending cuts over the next decade (Kogan 2012). Again ignoring the sequester, the BCA reduced discretionary spending for the current 2013 fiscal year by $107 billion (0.7 percent of GDP) relative to inflation-adjusted 2010 discretionary spending levels. This is a bigger cut than the sequester scheduled for fiscal 2013 by the BCA. In short, discretionary federal fiscal policy is joining state and local budgets on the austerity path.

Of the resolutions to the “fiscal cliff” under serious consideration, all would have exacerbated federal fiscal policy’s economic drag.8 For example, if the deficit reduction scheduled at the end of 2012 had fully taken effect—i.e., if the “current law” scenario had come to pass—the budget deficit would have continued contracting rapidly, reaching 4.0 percent of GDP in fiscal 2013 and 2.4 percent in fiscal 2014 (CBO 2012d). Under this scenario, real GDP would have fallen 0.5 percent by the end of 2013, resulting in an output gap of about $1.3 trillion (CBO 2012e), or 7.7 percent below potential output, as shown in Figure I.9 (The output gap is the difference between potential economic output—what the economy could produce with higher, but noninflationary, levels of employment and industrial capacity utilization—and actual economic output.) If Congress had instead adhered to the “current policy” baseline (i.e., assuming sequestration would not occur and the Bush-era tax cuts and routinely renewed provisions would be continued), the budget deficit would still have contracted rapidly, to 6.4 percent of GDP in fiscal 2013 and 5.4 percent in fiscal 2014. Under this current policy scenario, real GDP growth would have further decelerated to just 1.4 percent, and the output gap would have registered above $1.0 trillion by the end of 2013, as depicted in Figure I (Fieldhouse 2012a).10

Figure I

If Congress had instead “deactivated” all the major components of the “fiscal cliff” (i.e., additionally continuing the payroll tax cut and emergency unemployment benefits, as well as repealing the BCA discretionary spending caps), real GDP growth would have risen to 3.1 percent for 2013. This is certainly an improvement, but as Figure I depicts, the output gap would have been projected at $734 billion—or 4.3 percent below potential output—by year’s end (Fieldhouse 2012a).11

In essence, the “fiscal cliff” debate was focused on whether the U.S. economy would end 2013 at 7.7 percent below potential output, 4.3 percent below potential output, or somewhere in between. A more productive debate would have been based on concrete estimates of what it would take to achieve a full economic recovery. Yet the implicit policy question in today’s fiscal debate remains centered on deciding just what level of depressed economic activity should be targeted in 2013.

“Fiscal cliff” resolution entails more austerity

The American Taxpayer Relief Act of 2012 (ATRA), the partial resolution to the “fiscal cliff” signed into law in early January 2013, failed to adequately moderate the pace of deficit reduction. This is because Congress gave more emphasis to dodging policies looming large in budgetary terms than policies looming large in economic terms.12 Ahead of the deal, merely adhering to the current policy baseline implied overly rapid deficit reduction and increased economic weakness; ATRA further shrank the projected budget deficit for 2013 relative to current policy. Relative to fully mitigating the “fiscal cliff” components, we estimate ATRA implies 2.1 percentage points shaved from real GDP growth and more than 2.4 million fewer jobs in 2013, if the sequester materializes (Fieldhouse 2013a; CBO 2013c).13

CBO’s subsequently published February 2013 economic forecast estimates real GDP growth of just 1.4 percent for 2013, and an output gap of more than $1.0 trillion, or 6.0 percent of GDP, persisting in the fourth quarter (CBO 2013d). This current law economic forecast assumes that sequestration will take effect on March 1, as currently scheduled (the cuts were delayed for two months by ATRA). We estimate sequestration would reduce real GDP growth by 0.6 percentage points (Fieldhouse 2013a). So even if the entire sequester were repealed without offsets—the optimal but seemingly unlikely policy outcome—average real GDP growth would be expected at roughly 2.0 percent for the year. More likely, the sequester will be replaced with a mix of revenue increases and spending cuts; this would imply real GDP growth between 1.4 percent and 2.0 percent, depending on timing (i.e., how much austerity is scheduled for 2013) and the balance between less economically harmful revenue increases and more damaging spending cuts.14 Again, real GDP growth in this range would likely mean deterioration in the labor market and, at best, negligible progress toward restoring full employment.

Similarly, the output gap under a continuation of current policy would be projected at between $941 billion and more than $1.0 trillion by the fourth quarter of 2013, or 5.4 percent and 5.9 percent below potential output, respectively, depending on how much of the sequester is offset in 2013.15 This is squarely in line with the $995 billion output gap (5.9 percent of potential output) that prevailed in the fourth quarter of 2012 (CBO 2013a; BEA 2013a) and again suggests negligible progress in restoring the economy to full health—regardless of how Congress handles sequestration. Short of sharply reorienting fiscal policy to accommodate accelerated recovery, in 2013 U.S. trend economic growth will likely be insufficient to keep the labor market from deteriorating.

What it would take to ensure a full recovery

As just discussed, in 2013 federal fiscal policy will likely make no progress in shrinking the output gap. However, closing the gap by boosting aggregate demand remains the key to restoring full employment, which should be the top economic policy priority. Conventional monetary policy has been exhausted, and neither unconventional monetary policy nor other channels of currency depreciation seem capable of cushioning fiscal drags, let alone spurring faster growth rates than those experienced since mid-2009. Closing the output gap entirely through expansionary fiscal policy would likely require roughly $650 billion of deficit-financed fiscal stimulus in 2013, as well as substantial stimulus in 2014 and 2015 to avoid recurring “fiscal cliffs” in those years. All in all, we estimate policymakers truly committed to a full and durable recovery would need to target roughly $1.5 trillion to $2.2 trillion in additional fiscal support over the next three years.

Closing the output gap

While the United States officially entered a business cycle expansion in July 2009, the economy has operated 5 percent or more below potential output since the fourth quarter of 2008. And to close the roughly $1 trillion output gap, actual economic growth must outpace growth in the economy’s potential output (growth in potential productive capacity from rising productivity and labor force growth). CBO projects that growth in the economy’s real potential output will average 2.2 percent over 2012–2022—whereas real GDP growth has averaged a lesser 2.1 percent since recovery began in mid-2009, and the economy has slowed further below trend growth in productive capacity to an annualized 1.9 percent since mid-2010 (BEA 2013a; CBO 2013a). Markedly faster growth is needed to restore full employment. However, as previously discussed, the trajectory for federal fiscal policy implies a continuation of anemic growth below potential and under levels necessary to improve the labor market—absent an abrupt, much-needed change of policy.

Dropping all political constraints, EPI’s budget roadmap, Investing in America’s Economy: A Budget Blueprint for Economic Recovery (Bivens et al. 2012), identified and actually budgeted for what we estimated it would take to absolutely ensure full and sustained economic recovery.16 Our budget initially increased non-interest government spending in fiscal 2013 by $761 billion relative to pre-ATRA current policy. We estimated this would provide roughly enough cost-effective discretionary fiscal stimulus (more efficient on average than, say, the payroll tax holiday in effect in 2011 and 2012) to close the output gap.17 Bigger budget deficits to boost aggregate demand would also have been required relative to current policy in 2014 and 2015 to avoid setting up future “fiscal cliffs.” Our budget financed a total of $2.2 trillion of increased non-interest spending over fiscal 2013–2015, relative to current policy. Net of phasing in progressive tax increases, our budget would have increased deficits by $1.2 trillion over fiscal 2013–2015, relative to current policy. We would have pushed the budget deficit to $1.6 trillion (10.3 percent of GDP) in fiscal 2013 and $1.3 trillion (8.0 percent of GDP) in fiscal 2014. This represented an increase of $610 billion and $438 billion, respectively, relative to pre-ATRA current policy. These increases in deficits, however, ignore the positive budgetary feedback effect of higher economic output, as projected near-term cyclical budget deficits would dissipate with a rapidly accelerated return to full employment.18

After we released our budget blueprint, ATRA was passed and the CBO revised its economic forecast (CBO 2013d); however, the requisite fiscal push to restore the economy to full health is roughly the same. Adjusting CBO’s forecast for current policy, closing the roughly $1.0 trillion output gap for 2013 would require roughly $650 billion in deficit-financed efficient economic support in 2013 alone, with additional stimulus needed in subsequent years to generate a self-sustaining recovery. CBO’s current law forecast shows cumulative output gaps of $2.6 trillion over 2013–2015, and alternative output gap projections based on trend economic performance (discussed below) suggest cumulative output gaps of as much as $3.1 trillion over this period. Adjusting for current policy, we estimate that ensuring the closure of these output gaps with deficit-financed efficient fiscal support would require somewhere in the ballpark of $1.5 trillion to $2.2 trillion of government spending over the next three years, assuming sequestration does not occur.19 The higher end of this range assumes that every penny of near-term output gaps must be closed through additional fiscal support, while the lower end allows for some renewed positive influence of monetary policy support in the later years.

Why fiscal policy is the answer

It could be argued that this proposal is too economically ambitious (it is clearly too politically ambitious) because it essentially assumes the entire output gap must be closed through fiscal policy. This seems a prudent assumption, however. Conventional monetary policy has had little effect on the economy for nearly four years now, with short-term policy interest rates standing at ostensibly zero since December 2008. Indeed, the Fed has publicly assured that its short-term policy rates will remain at their current near-zero levels until at least mid-2015, and will certainly not change until either the unemployment rate falls below 6.5 percent or near-term inflation expectations exceed 2.5 percent (FOMC 2012a; FOMC 2012b).

Further, monetary policy is only likely to regain traction and help boost the economy if expectations are that inflation rates are not likely to fall in coming years (falling inflation rates are to be expected during times of very low interest rates and large output gaps). However, a crucial determinant of these inflation expectations is the degree of fiscal support and expectations of future output growth. More simply, even if we reach, say, 6.5 percent unemployment, it seems far from clear that monetary policy alone could sustain the economy’s growth in the face of rapid fiscal contraction. By far the most risk-averse policy is to assume that the entire output gap must be filled through fiscal expansion, with monetary policy being used to perpetuate growth in the face of fiscal consolidation after full employment is achieved.

If instead fiscal contraction begins before this return to full employment, the current adverse equilibrium of large output gaps, anemic growth, big cyclical budget deficits, low interest rates, and subdued inflationary pressure could persist for years to come, at a staggering opportunity cost. And between low interest rates and reducing costly long-run “economic scarring” from underutilized productive resources, there is compelling evidence that such fiscal expansion would be more than self-financing over the long run (DeLong and Summers 2012).

Given the misplaced political emphasis since 2010 on deficit reduction, adding roughly $600–700 billion in deficit-financed stimulus to next year’s budget is obviously politically impossible. This demonstrates that policymakers are essentially refusing to discuss a guaranteed return to full employment.

Long-term consequences of failing to guarantee a return to full employment

The U.S. economy has already forfeited trillions of dollars in national output because policymakers have failed to prioritize a return to full employment. And the corollary to trillions of dollars of forgone output is essentially trillions of dollars of lost national income. The longer this failure persists, the more damage the economy will sustain. As alluded to previously, knock-on effects of this policy failure include damage to future potential income from economic “scarring.” Put simply, allowing productive economic resources (both people and capital) to sit idle and atrophy is an exceptionally inefficient economic policy decision (Irons 2009; CBO 2012d; Fieldhouse 2012b). It is also one that will lead to larger deficits over the medium and long term. Indeed, far too many self-proclaimed deficit hawks fail to realize that a rapid recovery would do much to reduce long-term budget deficits (the ones that pose theoretical risks), largely by ensuring against larger cyclical budget deficits than are currently being projected.

Expanding output gaps over the medium and long term

Output gaps to date show that the United States has cumulatively forgone $4.5 trillion of national income between 2008 and the end of 2012, and CBO current law economic projections imply another $2.8 trillion worth of cumulative output gaps over 2013–2017.20 These forecasts are likely overstated in the near term given that Congress will probably repeal sequestration, either without offsets or with offsetting spending cuts and revenue increases phased in over a decade. Still, CBO’s current economic forecast indicates a decade-long slump in which the United States will forgo $7.3 trillion of national income. Even if slightly overstated in the short term, this is a staggeringly large number.

Moreover, even this bleak outlook presumes the U.S. economy will naturally and rather quickly (once the process begins) attain growth rates sufficient to reach its full economic potential over the next four years or so. CBO’s February 2013 economic forecast shows recovery rapidly accelerating starting in late 2013, with real GDP growth averaging 4.0 percent over 2014–2016 (roughly twice trend growth since recovery began). Should it materialize, this spurt of growth exceeding potential GDP growth would close the output gap within roughly the next four years. But as an empirical matter, the CBO projections have consistently issued premature dates for when full recovery will occur. For example, the 2014 full recovery expected in CBO’s January 2010 forecast is now projected for 2017. As depicted in Figure J, CBO’s forecasts have consistently shown full recovery to be an elusive four years away. It is thus a deeply risky economic strategy to rely on such forecasts instead of ensuring a return to full employment through fiscal policy.

Figure J

On a more theoretical level, the CBO projections basically assume that the economy has natural mechanisms that push it back toward its potential after experiencing negative shocks. This is a standard modeling assumption, and a reasonable one when the economy is not mired in a liquidity trap. Such mechanisms do exist, although the most powerful mechanisms are not market forces, but rather institutional forces. For example, when the economy experiences a negative shock, falling tax collections and rising safety net spending—i.e., bigger budget deficits—automatically serve as shock absorbers. Similarly, the Federal Reserve deliberately loosens monetary policy when the economy is depressed.

However, these mechanisms for pushing the economy back toward full employment today are clearly too weak. Automatic fiscal stabilization helps, but it must be supplemented with discretionary stimulus. As noted previously, this stimulus has now completely faded—and state and local governments have been a consistent drag on growth throughout the whole crisis. Furthermore, while monetary policy has clearly helped, it has only been sufficient to moderate the downturn. This can be seen in how utterly dependent recovery has been on fiscal policy changes (as illustrated in a previous section).

Assuming expansionary fiscal policy continues to be the only mechanism capable of pushing the economy to full employment, what will occur over the next decade if fiscal policy becomes as contractionary as is forecast under current policy? One way to extrapolate trend economic performance over the next decade is to hold the output gap constant at 5.9 percent of potential GDP (where it stood in the fourth quarter of 2012) from 2013 to 2022. This is a possible outcome of current budget policy (albeit a slightly conservative estimate, given the trajectory for fiscal policy) without an exogenous boost to growth (e.g., an improvement in the trade deficit or a spike in residential investment). Alternatively, one can model what happens if real GDP from 2013 to 2022 continues to grow at the 2.1 percent annualized rate that has characterized recovery to date. Both projections show comparable, mammoth economic losses—all without the economy ever entering official recession—and an average of these two extrapolations is our preferred projection for sustained trend economic performance. Under this alternative growth projection, the U.S. economy would be $1.1 trillion smaller than under CBO’s forecast in 2017, when CBO assumes full recovery. The cumulative output gap would increase by roughly $8.4 trillion over fiscal 2013–2022 in addition to the $7.3 trillion in forgone output to date. The economy would be 6.5 percent smaller by the end of fiscal 2022 than under CBO’s projection, as depicted in Figure K. This risk is of greatest concern for broad-based living standards, but for those professing concern about the sustainability of public debt, it would also mean the debt-to-GDP ratio would be 7.0 percent higher, everything else being equal.

Figure K

Bigger deficits due to economic stagnation

Budget hawks should have an additional reason to be concerned about expanding output gaps: As a rule of thumb, every dollar the economy moves away from potential GDP adds $0.37 to the cyclical budget deficit through decreased tax receipts and increased automatic safety net spending (Bivens and Edwards 2010). This implies that adding $8.4 trillion to the output gap between fiscal 2013 and 2022 would increase primary budget deficits (deficits that exclude interest payments) by roughly $3.1 trillion over that period. Adjusting from chained 2012 dollars to the nominal dollars used in CBO’s February 2013 budget forecasts (to comport with budget scorekeeping conventions), this would represent a $3.5 trillion increase in cyclical budget deficits over the CBO’s baseline forecast—perhaps better thought of as a $3.5 trillion “failure to restore full recovery tax.”21 (This compares with primary deficits of $2.2 trillion and total cumulative deficits of $7.2 trillion projected under current policy over the same period.)

However, much worse than these budgetary effects are the implications of continued stagnation for joblessness, economic stress on American families, and future long-run growth. Regarding the latter point, CBO has lowered its estimate of potential output in 2022 by 1.5 percent as a result of the recession (CBO 2012b). For an economy projected to then be approaching $25 trillion, that amounts to a $382 billion loss in productive potential in a single year.22 Without markedly faster growth, potential output will continue reverting toward depressed actual output through economic scarring. This is an exceptionally inefficient waste of human and economic potential—and one that adds to budget deficits.

Conclusion

During the Great Depression, the U.S. economy grew when policymakers provided monetary and fiscal support (mostly between 1933 and 1936), but faltered when this support was withdrawn. It only fully recovered when external events (i.e., the defense boom spurred by World War II) demanded a huge fiscal expansion. As discussed previously, Japan in the 1990s and early 2000s followed a similar pattern of erratic growth due to inconsistent monetary and fiscal support, with the United Kingdom appearing to be stuck in the same pattern today. The United States must avoid similar self-inflicted and thoroughly counterproductive economic damage.

The top policy priority must be ensuring a rapid return to full employment. It is time to stop taking for granted the automatic return to full employment presumed by the policymaking elite, and instead use proven policy levers to force its return. The most effective of these remains deficit-financed government spending to close the shortfall in aggregate demand. Over each of the next few years, policymakers should target budget deficits roughly $600–700 billion larger than projected under current policy. Only by doing so can the United States guarantee that decades of rising income and living standards are not needlessly forfeited. The opportunity cost of sustained economic weakness in terms of living standards, inequality, the fiscal outlook, and economic scarring to potential productive resources is simply too high to jettison 80 years’ worth of hard-earned economic knowledge. In contrast to the conventional wisdom that big budget deficits are immoral and economically damaging, big budget deficits have ended a recession and sustained anemic recovery. Continuing to close them too quickly risks a second recession and continued economic weakness.

Preferences of the policymaking elite and the broader economic policy discourse are far removed from such an acknowledgement—and an aggressive reorientation of fiscal policy, such as the one proposed in this paper, is often brushed off as politically infeasible. Sadly, the thoroughly inadequate policy response of this same political elite also explains why, five years after the onset of the Great Recession, the U.S. economy remains extraordinarily weak and risks a second lost decade of deteriorating—or, at best, stagnant—living standards for lower- and middle-income households.

Conventional fiscal policy debates inside the Beltway in recent years have focused mostly on the dangers posed by unhealthily large structural budget deficits projected to be run when the economy has returned to full employment. (Again, this concern ignores the likelihood of additional cyclical budget deficits if the return to full employment does not materialize as soon as projected.)

Besides noting how remote these dangers are, we should also point out that even if the economy rebounded much, much faster than anybody is currently predicting, there is little danger our policy recommendations would be damaging. If, for example, our policy recommendations were followed and budget deficits exceeded those projected under current policy in 2014 and 2015 even in an economy that had staged a strong return to full employment, the only cost would be higher interest rates that threatened to crowd out some private-sector investments.23 But since so much of our plan relies on expanded public-sector investments, the economy’s overall capital stock would still register strong growth. And given much research showing that the marginal return to U.S. public investment probably exceeds that of private investment, it is very hard to argue that our policy recommendations would inflict any economic damage, even in the unlikely case that the economy staged a very strong recovery on its own (Bivens 2012a).

In short, the real policy risk here is inaction and failure to ensure a return to full employment. Unfortunately, this risk seems all but certain of coming to pass.

— Josh Bivens joined the Economic Policy Institute in 2002 and is currently the director of research and policy. His primary areas of research include mac­roeconomics, social insurance, and globalization. He has authored or co-authored three books (including The State of Working America, 12th Edition) while working at EPI, edited another, and has written numerous research papers, including for academic journals. He appears often in media outlets to offer eco­nomic commentary and has testified several times before the U.S. Congress. He earned his Ph.D. from The New School for Social Research.

— Andrew Fieldhouse is a federal budget policy analyst with the Economic Policy Institute and The Century Foundation. He previously worked as an assistant budget analyst and research assistant with the House Budget Committee. His areas of research and interest include federal tax and budget policy, political economy, public investment, and macroeconomics. Andrew has provided frequent commentary on the current budget debate and the impact of fiscal policy on the economic recovery.

— Heidi Shierholz joined the Economic Policy Institute as an economist in 2007. She does research on employment, unemployment, and labor force participation; the wage, income, and wealth distributions; the labor market outcomes of young workers; unemployment insurance; the minimum wage; and the effect of immigration on wages in the U.S. labor market. She previously worked as an assistant professor of economics at the University of Toronto, and she holds a Ph.D. in economics from the University of Michigan-Ann Arbor.

— The authors thank Hilary Wething for research assistance.

Endnotes

1. The National Bureau of Economic Research (NBER) Business Cycle Dating Committee dates U.S. business cycle peaks and troughs by month, based on aggregate economic activity measured across a number of economic indicators, notably “real GDP, real income, employment, industrial production, and wholesale-retail sales” (NBER 2013). Two consecutive quarters of real GDP contraction is a common proxy for recessions, and this rule of thumb is typically used in assessing recessions in Europe and much of the rest of the world. A depression, on the other hand, refers to actual economic output being depressed substantially below potential output regardless of whether the economy is in a recession or business cycle expansion. Often, economies oscillate between recessions and expansions while mired in depression (e.g., Japan in the 1990s and the United Kingdom since 2008).

2. This paragraph examines the average income of the middle fifth of families instead of median incomes because the former measure is available for a much longer period of time (from 1948 to 2011). This provides the statistical power to convincingly test the relationship between unemployment and income changes.

3. Note that demand here is defined the economists’ way: desire backed by purchasing power. Nobody doubts that the desire for goods and services still exists in American households and businesses. What is lacking is purchasing power, which has been dramatically reduced as home prices collapsed, unemployment rose, and real wages fell for the vast majority.

4. In particular, the fact that short-term interest rates controlled by the Federal Reserve have remained at ostensibly zero since December 2008 (nearly halfway through the recession) was—and remains—an impediment to interest rate cuts serving as the main recession-fighting tool. Fiscal expansion is more effective when conventional monetary policy is maxed out.

5. Annualized real GDP growth measured fourth quarter over fourth quarter. The 2.7 percent figure for the second half of 2009 is measured as two times the fourth quarter over second quarter growth for the second half of 2009.

6. For a full explanation of how this counterfactual level of government spending would have boosted overall growth, see Bivens and Finio (2013).

7. A more apt metaphor was that of a “fiscal obstacle course,” with the obstacles in question impeding, to varying degrees, faster recovery and lower unemployment. As such, adeptly moderating the pace of deficit reduction would require enacting cost-effective policies to spur demand (not necessarily constrained to “deactivating” various components of legislated restraint) while jettisoning economically ineffective policies. See Bivens and Fieldhouse (2012b) for a decomposition of the budgetary versus economic impacts of each of the major fiscal drags that had been legislated for 2013 prior to enactment of the American Taxpayer Relief Act of 2012 (ATRA), the partial resolution to the “fiscal cliff” signed into law in early January 2013.

A common misperception reinforced by the dominant “cliff” narrative was that the economy would “go over a cliff” on January 1, 2013. The fallacy of this concern was underscored by enactment of a stop-gap budget deal after this date had passed, with no catastrophic economic impacts to show for it. Economist Chad Stone of the Center on Budget and Policy Priorities offered the more apt moniker of a “fiscal slope,” because if no action were taken by the end of 2012, the economy would gradually decelerate in early 2013 (Stone 2012). Indeed, the problem of federal budget deficits shrinking too quickly began years ago—as reflected in the deceleration of growth since mid-2010. This deceleration was forecast to compound month-after-month into 2013, but policymakers could have averted a recession by taking action in the first few months of the year (Stone 2012). Tax filers newly falling into the alternative minimum tax for 2012 if it had not been patched would have owed no additional tax liability until April. Furthermore, Treasury Secretary Timothy Geithner could have delayed changing income tax withholding tables, so that most households’ disposable income would not have fallen even if all the Bush-era tax cuts lapsed for a few months before being partially reinstated retroactively. Sequestration cuts could also have been delayed later into 2013, but not indefinitely (Goldfarb 2012). The one major downward shift in annualized growth rates poised for the beginning of 2013 was the scheduled expiration of both emergency unemployment benefits and the payroll tax cut. Regrettably, this ad hoc stimulus was largely ignored in the policy debate, and the majority of this drag is now taking effect, as expiration of the payroll tax cut is decreasing disposable income.

8. Note that all calculations and numbers in the remainder of this section are based on CBO’s August 2012 budgetary and economic baseline forecast (CBO 2012c), the benchmark guiding policymakers during the “fiscal cliff” debate and enactment of ATRA.

9. In Figure I, 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 reflects a deepening economic contraction in the second quarter of 2013 under CBO’s August 2012 current law economic forecast. 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.

10. EPI’s pre-ATRA current policy baseline assumed extension of the 2001, 2003, and 2009 tax cuts; the 2010 estate and gift tax cuts; the AMT patch; and business tax extenders (roughly 80 expiring tax provisions routinely extended on an annual basis). The only temporary tax policy assumed to expire on schedule was the two-percentage-point employee-side payroll tax cut enacted for 2011 and extended for 2012. EPI’s current policy baseline also assumed that scheduled reductions to Medicare physician reimbursement rates would be prevented (i.e., the “doc fix” would be continued), the automatic sequester from the Budget Control Act of 2011 would not take effect, and force deployment and supplemental appropriations for overseas contingency operations would gradually decrease instead of growing with inflation. Note that in addition to assuming the payroll tax cut would expire on schedule, the current policy baseline assumed that the emergency unemployment compensation program would expire as scheduled at the end of 2012 and the phase-one discretionary spending caps from the BCA would remain in place, thereby dragging on growth (see Bivens and Fieldhouse 2012b).

11. Note that nearly half (47 percent) of the projected fiscal drag was projected to hit even under a continuation of current policy, because emergency unemployment benefits, the payroll tax cut, and discretionary spending caps loom relatively large in economic impact per dollar, unlike temporary income tax cuts and routinely extended provisions among the current policy adjustments.

12. Relative to current policy, ATRA ended the Bush-era income tax rate cuts for households with annual taxable income over $400,000 ($450,000 for joint filers), raised the top statutory capital gains and dividends rates to 20 percent for households above this threshold, reinstated the personal exemption phaseout and the limitation on itemized deductions for households with annual adjusted gross income above $250,000 ($300,000 for joint filers), and slightly raised the top estate tax rate to 40 percent. Below these cutoffs, ATRA permanently extended the Bush-era tax cuts. It also extended through 2017 the ARRA expansions of the refundable Earned Income Tax Credit, Child Tax Credit, and American Hope and Opportunity Tax Credit. Of the provisions typically renewed on an annual basis, most of the business tax extenders and the Medicare “doc fix” (which prevents cuts to physician reimbursement rates scheduled by the Sustainable Growth Rate formula) were continued for 2013, while the Alternative Minimum Tax parameters were permanently indexed to inflation. Additionally, the budget deal continued the Emergency Unemployment Compensation program for 2013, delayed the implementation of the sequester for two months, and enacted offsets—a mix of mandatory savings, downwardly revised discretionary spending caps, and revenue—to pay for the “doc fix” and the postponement of sequestration.

13. ATRA left in place sizable fiscal headwinds, most notably the expiration of the payroll tax cut, which is projected to shave 0.9 percentage points from real GDP growth and lower employment by nearly 1.1 million jobs, relative to 2012 fiscal policy. The sequester scheduled for the remaining ten months of the year implies a drag of 0.6 percentage points of real GDP and the loss of 660,000 jobs if it materializes, or if it is replaced with other spending cuts of comparable magnitude and timing (Fieldhouse 2013a; CBO 2013c). The phase-one BCA discretionary spending caps will ratchet down, shaving 0.4 percentage points from real GDP growth and reducing employment by roughly 530,000 jobs relative to pre-BCA law. The Emergency Unemployment Compensation program was extended, but only for a maximum duration of 73 weeks and to the cost of $30 billion in 2013, down from $39 billion in inflation-adjusted outlays for 2012 (when a maximum duration of 99 weeks was in effect for much of the year). This will result in a projected drag of 0.1 percentage point and 100,000 fewer jobs, relative to 2012 fiscal policy. Lastly, partial expiration of the upper-income Bush-era tax cuts is projected to shave less than 0.1 percentage point from real GDP growth and reduce employment by roughly 80,000 jobs, relative to 2012 fiscal policy.

14. For more on the way the composition of deficit reduction affects economic recovery, particularly the impact of revenue versus spending cuts, see Fieldhouse (2013b).

15. Current policy adjustments for GDP in the fourth quarter of 2013 are made for 25 percent of the fiscal 2014 budgetary cost of the “doc fix,” emergency disaster relief funding, and business tax extenders occurring in the fourth quarter of 2013 (CBO 2013b). Fiscal multipliers of 1.0, 1.4, and 0.32 are applied, respectively (following the precedent in Bivens and Fieldhouse 2012b). The range of estimates is based on sequestration occurring in full (hence no adjustment to current law forecasts) and sequestration being repealed in full (adjusting for the remaining fiscal year 2013 and 25 percent of the fiscal 2014 budgetary cost of sequestration). A fiscal multiplier of 1.4 is applied to sequestration.

16. The latest iteration of EPI’s budget blueprint was adapted for the Peter G. Peterson Foundation’s Solutions Initiative II, which convened five think tanks across the political spectrum to develop plans addressing our nation’s fiscal challenges in the context of the “fiscal cliff.”

17. Efficient fiscal stimulus is assumed to yield a fiscal multiplier of 1.4, Moody’s Analytics chief economist Mark Zandi’s most recent public estimate of the government spending multiplier (Zandi 2011). This is in line with other robust estimates of the government spending multiplier (Bivens 2012b; Blanchard and Leigh 2012).

Note that Investing in America’s Economy was scored relative to CBO’s August 2012 baseline, ignoring legislative changes from ATRA. Most of the difference between then–current law and then–current policy was composed of expiring tax policies and associated debt service, and ATRA largely bridged these differences without changing the current law baseline for primary spending beyond minor changes in 2013. And prior to ATRA, the current law baseline actually overstated primary spending relative to the current policy baseline. Note that economic and technical revisions to baseline projections for fiscal 2013–2022 between CBO’s August 2012 and February 2013 baselines totaled a negligible $128 billion improvement, leaving these calculations virtually unaffected by non-legislated revisions (CBO 2013e).

18. All dollars are nominal dollars from CBO’s August 2012 baseline (CBO 2012c).

19. Current policy adjustments for calendar years 2014 and 2015 follow the methodology in endnote 15, using 75/25 fiscal year/calendar year splits, and assume sequestration is repealed without offset. The current policy–adjusted CBO output gaps and our alternative output gaps (extrapolating trend performance through the fourth quarter of 2012, as discussed in the subsection “Expanding output gaps over the medium and long term”) are divided by 1.4, our multiplier assumption for efficient fiscal stimulus (see endnote 17), to roughly estimate the degree of fiscal support necessary to close the output gap. All calculations are in nominal dollars from CBO’s February 2013 baseline (CBO 2013a).

20. All estimates are in chained fourth quarter of 2012 dollars.

21. If the economy remained depressed and in a liquidity trap, neither Federal Reserve policy nor market forces would exert nearly as much upward pressure on interest rates as the rise projected in CBO’s economic forecast. Sustained economic weakness and failure to exit the prevailing liquidity trap would keep interest rates depressed along with the rest of the economy. Fixing debt service to keep annual net interest payments at 2.0 percent of nominal public debt (the average of actual and projected debt service as a share of public debt over fiscal 2011–2014, a reasonable proxy for liquidity trap rates) projected under current policy would reduce debt service by $1.7 trillion, relative to current policy. But this would still mean a net deterioration in the fiscal outlook of $1.8 trillion, relative to current policy.

22. Nominal dollars are presented to comport with budget scorekeeping conventions. This year is indicative of a broader trend, not an anomaly: CBO’s estimate for potential real GDP in 2020 has been downwardly revised by $809 billion (3.4 percent) between its January 2010 and February 2013 baselines (CBO 2010a; CBO 2013a).

23. An unexpectedly rapid return to full employment would also mean smaller near-term cyclical budget deficits and related federal borrowing, somewhat offsetting demand-side interest rate pressures.

References

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Bivens, Josh. 2012a. Public Investment: The Next ‘New Thing’ for Powering Economic Growth. Economic Policy Institute, Briefing Paper No. 338. http://www.epi.org/files/2012/bp338-public-investments.pdf

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Congressional Budget Office (CBO). 2008b. “Details of CBO’s Year-by-Year Forecast and Projections for Calendar Years 2008 to 2018 – January 2008” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/8917_TableC-1_0.xls

Congressional Budget Office (CBO). 2009a. “Historical and Projected Estimates of Potential GDP and the NAIRU – January 1991 to January 2009” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/2009-HistoricalQstar.xls

Congressional Budget Office (CBO). 2009b. “Details of CBO’s Year-by-Year Forecast and Projections for Calendar Years 2009 to 2019 – January 2009” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/Winter09_TableC-1_Hist.xls

Congressional Budget Office (CBO). 2010a. “Historical and Projected Estimates of Potential GDP and the NAIRU – January 2010” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/KeyAssumptionsPotentialGDP_0.xls

Congressional Budget Office (CBO). 2010b. “Details of CBO’s Year-by-Year Forecast and Projections for Calendar Years 2010 to 2020 – January 2010” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/Year-by-YearForecast_0.xls

Congressional Budget Office (CBO). 2011a. “Historical and Projected Estimates of Potential GDP and the NAIRU – January 2011” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/KeyAssumptionsPotentialGDP_110125.xls

Congressional Budget Office (CBO). 2011b. “Details of CBO’s Year-by-Year Forecast and Projections for Calendar Years 2010 to 2021 – January 2011” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/Year-by-YearForecast_110125_1.xls

Congressional Budget Office (CBO). 2012a. “Key Assumptions in Projecting Potential GDP—January 2012 Baseline” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/KeyAssumptionsPotentialGDP_1.xls

Congressional Budget Office (CBO). 2012b. “Baseline Economic Forecast—January 2012” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/Jan2012_EconomicBaseline_Release.xls

Congressional Budget Office (CBO). 2012c. “Baseline Economic Forecast—August 2012” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43542-AugustUpdate-Economic_Baseline_Projections.xls

Congressional Budget Office (CBO). 2012d. An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022. http://www.cbo.gov/sites/default/files/cbofiles/attachments/08-22-2012-Update_to_Outlook.pdf

Congressional Budget Office (CBO). 2012e. “Key Assumptions in Projecting Potential GDP—August 2012 Baseline” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43541-AugustUpdate-Key_Assumptions_Potential_GDP.xls

Congressional Budget Office (CBO). 2013a. “Key Assumptions in Projecting Potential GDP—February 2013 Baseline” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43910_KeyAssumptionsProjectingPotentialGDP.xls

Congressional Budget Office (CBO). 2013b. “Budget Projections—February 2013 Baseline Projections” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43905_BudgetProjections.xls

Congressional Budget Office (CBO). 2013c. “Estimate of the Budgetary Effects of H.R. 8, the American Taxpayer Relief Act of 2012, as passed by the Senate on January 1, 2013” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/American%20Taxpayer%20Relief%20Act.pdf

Congressional Budget Office (CBO). 2013d. “Baseline Economic Forecast—February 2013 Baseline Projections” [data table]. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43902_EconomicBaselineProjections.xls

Congressional Budget Office (CBO). 2013e. The Budget and Economic Outlook: Fiscal Years 2013 to 2023. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43907_Outlook_2012-2-5_Corrected.pdf

Current Population Survey Annual Social and Economic Supplement. Historical Income Tables. Various years. http://www.census.gov/hhes/www/income/data/historical/index.html

Current Population Survey basic monthly microdata. Various years. Survey conducted by the Bureau of the Census for the Bureau of Labor Statistics [machine-readable microdata file]. http://www.bls.census.gov/cps_ftp.html#cpsbasic

Current Population Survey public data series. Various years. Aggregate data from basic monthly CPS microdata are available from the Bureau of Labor Statistics through three primary channels: as Historical ‘A’ Tables released with the BLS Employment Situation Summary (http://www.bls.gov/data/#historical-tables), through the Labor Force Statistics Including the National Unemployment Rate database (http://www.bls.gov/cps/#data), and through series reports (http://data.bls.gov/cgi-bin/srgate).

DeLong, J. Bradford, and Lawrence H. Summers. 2012. Fiscal Policy in a Depressed Economy. Brookings Institution. http://delong.typepad.com/20120320-conference-draft-final-candidate-delong-summers-brookings-fiscal-policy-in-a-depressed-economy-1.32.pdf

Federal Open Market Committee (FOMC). 2012a. “FOMC Statement, October 24, 2012.” Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/newsevents/press/monetary/20121024a.htm

Federal Open Market Committee (FOMC). 2012b. “FOMC Statement, December 12, 2012.” Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm

Fieldhouse, Andrew. 2012a. “Since When Do We Congratulate Ourselves Just for Not Going Over a Cliff?” Working Economics (Economic Policy Institute blog), November 19. http://www.epi.org/blog/fiscal-cliff-economic-output-gap/

Fieldhouse, Andrew. 2012b. “Failure to Stimulate Recovery Is Costing Trillions in Lost National Income.” Working Economics (Economic Policy Institute blog), November 5. http://www.epi.org/blog/failure-stimulate-recovery-costing-trillions/

Fieldhouse, Andrew. 2013a. “At Best, Budget Deal Suggests Decelerating Anemic Growth, Labor Market Deterioration.” Working Economics (Economic Policy Institute blog), January 3. http://www.epi.org/blog/budget-deal-anemic-growth-labor-market-deterioration/

Fieldhouse, Andrew. 2013b. “The Importance of Revenue Revisited: Minimizing the Drag of Austerity.” Working Economics (Economic Policy Institute blog), January 24. http://www.epi.org/blog/revenue-revisited-minimizing-the-drag-of-austerity/

Goldfarb, Zachary. 2012. “To Blunt ‘Fiscal Cliff’ Pain, Administration Could Assert Broad Powers, Experts Say.” Washington Post, November 2. http://www.washingtonpost.com/business/economy/to-blunt-fiscal-cliff-pain-administration-could-assert-broad-powers-experts-say/2012/11/02/66a075ee-238d-11e2-ac85-e669876c6a24_story.html

Graham, Jed. 2013. “CBO: Deficit Shrinking At Fastest Pace Since WWII As GDP Sputters.” Investor’s Business Daily’s Capitol Hill blog, February 5. http://news.investors.com/blogs-capital-hill/020513-643238-dc-deficits-before-growth.htm

Irons, John. 2009. Economic Scarring: The Long-Term Impacts of the Recession. Economic Policy Institute, Briefing Paper No. 243. http://www.epi.org/page/-/img/110209scarring.pdf

Kogan, Richard. 2012. Congress Has Cut Discretionary Funding By $1.5 Trillion Over Ten Years: First Stage of Deficit Reduction Is in Law. Center on Budget and Policy Priorities. http://www.cbpp.org/cms/index.cfm?fa=view&id=3840

Krugman, Paul. 2011. “The Lesser Depression.” New York Times, July 22. http://www.nytimes.com/2011/07/22/opinion/22krugman.html

Mishel, Lawrence, Josh Bivens, Elise Gould, and Heidi Shierholz. 2012. The State of Working America, 12^th Edition. An Economic Policy Institute book. Ithaca, N.Y.: Cornell University Press.

Moody’s Analytics. 2012. Moody’s Economy.com, MyEconomy.com [subscription-only database].

National Bureau of Economic Research (NBER). 2013. “US Business Cycle Expansions and Contractions” [data table]. http://www.nber.org/cycles.html

Organisation for Economic Co-operation and Development (OECD). Various years. OECD. Stat Extracts [databases]. http://stats.oecd.org/

Pollack, Ethan. 2011. “Two Years into Austerity and Counting…” Working Economics (Economic Policy Institute blog), October 19. http://www.epi.org/blog/years-austerity-counting/

Posen, Adam. 2010. “The Realities and Relevance of Japan’s Great Recession: Neither Ran Nor Rashomon.” STICERD Public Lecture, London School of Economics, May 24. http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech434.pdf

Shierholz, Heidi. 2012. Labor Force Participation: Cyclical Versus Structural Changes Since the Start of the Great Recession. Economic Policy Institute, Issue Brief No. 333. http://www.epi.org/files/2012/ib333-labor-force-participation-since-great-recession.pdf

Shierholz, Heidi, and Josh Bivens. 2012. “Three Years into Recovery, Just How Much Has State and Local Austerity Hurt Job Growth?” Working Economics (Economic Policy Institute blog), July 6. http://www.epi.org/blog/years-recovery-state-local-austerity-hurt/

Stone, Chad. 2012. Misguided “Fiscal Cliff” Fears Pose Challenges to Productive Budget Negotiations: Failure to Extend Tax Cuts Before January Will Not Plunge Economy into Immediate Recession. Center on Budget and Policy Priorities. http://www.cbpp.org/cms/index.cfm?fa=view&id=3788

Wilson, Daniel. 2011. Fiscal Spending Jobs Multipliers: Evidence from the 2009 American Recovery and Reinvestment Act. Federal Reserve Bank of San Francisco, Working Paper 2010-17. http://www.frbsf.org/publications/economics/papers/2010/wp10-17bk.pdf

Zandi, Mark. 2011. “At Last, the U.S. Begins a Serious Fiscal Debate.” Moody’s Analytics, April 14. http://www.economy.com/dismal/article_free.asp?cid=198972

Broadly speaking, their bill would replace the entirety of the pending automatic “sequestration cuts”—now legislated to commence March 1—with $948 billion in progressive revenue (much of which was proposed in the CPC’s budget fiscal 2013 alternative, the Budget for All) coupled with $276 billion in near-term economic stimulus, paid for with $278 billion in cuts to spending by the Department of Defense. Replacing the sequester with revenue would bring net spending cuts and revenue increases roughly to a 1:1 ratio, and the DOD spending reductions would bring nondefense and defense discretionary spending cuts to a 1:1 ratio (measuring deficit reduction since the start of the 112^th Congress, notably $1.5 trillion in discretionary spending cuts and $633 billion in policy savings from the lame duck budget deal). And most critically, the bill would balance deficit reduction with near-term measures boosting growth and employment, while making the composition of deficit reduction less economically damaging than scheduled.

With Congress having voted to suspend the statutory debt ceiling until May 19—preventing, for the time being, the threat of sovereign default being used to extract spending cuts—the next big budget and economic policy fight will be over sequestration, which the American Taxpayer Relief Act of 2012 (i.e., the lame duck deal, or ATRA for short) merely prevented for two months. Under current law, the Budget Control Act (BCA) of 2011 still requires the Office of Management and Budget to sequester (i.e., cut) $948 billion of government spending, split between defense and nonexempt domestic programs, over the next decade. Remember, the sequester was designed to be so politically unpalatable and damaging (as a share of GDP, the scheduled cuts are frontloaded—a terrible design for economic recovery and programmatic implementation) that it would force the since-disbanded Joint Select Committee on Deficit Reduction to compromise on more sensible deficit reduction. Clearly, that never happened.

But as we have previously explained, ATRA left in place sizable fiscal headwinds for 2013 by inadequately mitigating the two largest biggest economic drags among the major components of the fiscal obstacle course—the expiration of ad hoc fiscal stimulus and the BCA. The payroll tax cut was allowed to expire, emergency unemployment benefits were extended (but at a shorter duration and smaller economic boost than for most of 2012), and the first BCA phase of discretionary spending caps were entirely unaddressed. Relative to fully mitigating the fiscal obstacle course drags, the trajectory for federal fiscal policy implies a drag of between 1.5 percentage points and 2.1 percentage points, depending on whether the sequester materializes or, if avoided, the degree to which and when it’s repeal is offset. Adjusting from CBO’s August 2012 economic forecast, this would imply anemic real GDP growth of 1.0 percent to 1.6 percent—estimates consistent with those of Goldman Sachs, among others—suggesting renewed deterioration in the distressed labor market, as trend real growth rates of 2.0 percent to 2.5 percent are needed just to keep the unemployment rate treading water.

Just as austerity measures can easily scuttle a depressed economy’s recovery, increased spending to boost demand is the most effective policy lever for accelerating growth. The Balancing Act would boost growth by investing $150 billion in near-term surface transportation infrastructure, $10 billion to establish an infrastructure bank, $55 billion in K-12 school modernization and rehiring teachers, and $61 billion to reinstate the Making Work Pay (MWP) tax credit for 2013. These are all cost-effective job-creation measures with fiscal multipliers (the amount of economic activity generated by year’s end per dollar spent) exceeding 1, meaning that this would actually reduce the debt-to-GDP ratio next year.1 Increasing public investment is a no-brainer in the midst of a jobs crisis and during a period of near-record low financing costs (it’s largely self-financing in the near-term and public investment is a key driver of long-term productivity growth). Reinstating MWP would cushion the impact of expired payroll tax cut for lower- and middle-income households—at half the cost of the payroll tax cut because of its more progressive phase-in and phase-out rates.

On net, we estimate that these stimulus measures would boost real GDP growth by 1.0 percentage point in 2013, increasing nonfarm payroll employment by over 1.2 million jobs for the year, relative to current policy. These calculations, however, ignore any near-term economic drags from cutting defense spending and (lesser drags) from progressive revenue increases due to data limitations (there is no year-by-year CBO cost estimate). But these pay-fors have the advantage of minimizing near-term fiscal headwinds because progressive revenue increases are, per dollar, the least economically damaging option for deficit reduction and the DOD cuts would presumably be back loaded. Based on proxy phase-in rates, the combination of progressive revenue increases and DOD cuts might reduce the net stimulative impact by 0.2 percentage points real GDP growth and roughly 270,000 jobs, again relative to current policy.2 But that would still mean a net boost of 0.8 percentage points to growth and nearly 1 million additional jobs by the end of 2013. This would likely reorient federal fiscal policy from slowing growth to the point of a deteriorating labor market to actually boosting trend growth for the year (based on our estimate of 1.6 percent real GDP growth without sequestration).

Note also that the current policy baseline used in the above calculations assumes sequestration will not occur, which is by no means guaranteed. Should sequestration take effect for the remainder of 2013, we estimated it would slow growth by 0.6 percentage points and reduce employment by 660,000 jobs—and outcome that the Balancing Act would ensure against.

Deficit reduction should take a back seat to restoring full employment, period: if depression and cyclical budget deficits persist, contrary to CBO’s forecast, the fiscal outlook deteriorates markedly and trillions of dollars of actual income and potential future income will be forgone. But if political constraints dictate otherwise, weighting the composition of budgetary savings heavily toward progressive revenue and coupling savings with near-term stimulus spending is the evidence-based second best approach. The Balancing Act would accelerate growth and lock in more efficient, less economically damaging deficit reduction than that enacted to date, while stimulus spending would actually improve the debt-to-GDP ratio. That’s as sound as Congressional budget policy gets these days.

1. According to Moody’s Analytics chief economist Mark Zandi, the fiscal multiplier is 1.44 for infrastructure investment, 1.31 for general aid to state governments (i.e., funds for rehiring teachers), and 1.18 for MWP.

2. Year-by-year progressive revenue increases are modeled from the bill’s stated ten-year total using the implicit phase-in rate for upper-income tax provisions from OMB’s Mid-Session Review of the president’s budget request for fiscal 2013. Year-by-year DoD cuts are modeled from the ten-year total using the implicit phase-in rate for base DoD cuts from the CPC’s Budget for All. Fiscal multipliers of 0.35 and 1.4 are assigned, respectively (Zandi’s estimate for extending all the Bush tax cuts—an intentionally conservative estimate—and general government spending, respectively).

Klein hones in on tables depicting the fundamentally unbalanced nature of deficit reduction in the 112th Congress: Ignoring sequestration, 70 percent of policy deficit reduction measures (i.e., excluding additional debt service savings) enacted came from spending cuts as opposed to revenue, and if sequestration takes effect as scheduled, the share of spending cuts ratchets up to 80 percent. Murray’s memo contrasts these ratios with a 51 percent revenue share proposed by the Simpson-Bowles Co-Chairs’ report and 52 percent in the Senate’s bipartisan “Gang of Six” proposal. Hence Murray’s conclusion:

“Revenue Must be Included in Any Deal. Tackling our budget challenges requires both responsible spending cuts and additional revenue from those who can afford it most.”

She’s absolutely right, but the memo hits only on the budgetary half of why compositional balance is important. Accepting on face value that the 113th Congress will pursue more deficit reduction measures (more forthcoming from us on this premise)—at the very least replacing sequestration in chunks or entirety—including progressive revenue is critical for minimizing the economic drag of austerity. As we’ve explained before, revenue increases on upper-income households and corporations are, per dollar, the least economically damaging policy option for deficit reduction—see the table below. (Again, why policymakers are abandoning what works and fixating on damaging an economy already depressed nearly $1 trillion—or 5.6 percent below potential output—with bleak prospects for emerging from depression, is a question for another post.) Some simple math helps underscore the benefit of increasing the revenue share in hitting a fixed deficit reduction target.

Replacing the blunt, intentionally unpalatable sequester, which would require annual cuts of $109 billion totaling $984 billion over nine years, will be the next budget fight, so offsetting this austerity is an illuminating framework. The government spending multiplier—meaning the economic impact of a dollar of government spending—is estimated at 1.4, so $109 billion in spending cuts would knock $153 billion off gross domestic product (GDP).2 For a $15.9 trillion U.S. economy (Congressional Budget Office’s latest projection for 2013), that would amount to a hit of just less than 1.0 percent of GDP. But the fiscal multiplier for a permanent increase in the corporate income tax rate is just 0.32, and we impute an even lower multiplier of 0.25 for tax increases on upper-income households. (Murray’s letter emphasizes curbing tax expenditures for upper-income households and corporations, which if anything would have slightly lesser impacts on demand per dollar.)

So if this sequester cut were to be contemporaneously replaced with revenue from corporations or upper-income households, the economic drag would fall to $35 billion or $27 billion, respectively—just 23 percent or 18 percent, respectively, of the drag imposed by an equivalent dollar amount of spending cuts. The more you shift the composition of any sequester offset toward progressive revenue, the less austerity will retard growth in 2013 and beyond. At a 1:1 ratio of spending cuts to revenue from upper-income households, the damage from $109 billion in policy savings falls to $90 billion (0.6 percent of GDP), or just 59 percent of the drag from an equivalent dollar amount of spending cuts. This result holds especially valid while the economy remains depressed—the next four years as currently projected by CBO, though likely longer if fiscal policy remains deeply contractionary. (Relatedly, maximally delaying offsets or inevitable deficit reduction until the economy is back to full health would also be highly advisable.)

In other words, balanced deficit reduction is critical not just for protecting the basic functioning of government, social insurance (Medicare, Medicaid, and Social Security), public investment, and more broadly the progressivity of the tax and transfer system—it’s critical for minimizing the economic damage of the premature austerity that Congress misguidedly remains hell-bent on enacting.

In a sane world, the sequester would simply be repealed without offsets—which would still leave real GDP growth in the ballpark of an anemic, inadequate 1.6 percent for 2013—and deficit-financed spending would be used to boost demand and ensure a return to full employment. We previously estimated that $700 billion of deficit-financed spending would be needed in 2013 and sustained for several years to return full employment—the equivalent of roughly three more Recovery Acts. But given the misguided obsession with austerity at hand, maximizing the share of progressive revenue in expected subsequent deficit reduction measures is a decent second-best option. To that extent, Murray’s emphasis on balance and progressive revenue is encouraging, albeit from a very low bar in economic policy management.

Endnotes

1. As a side note, it’s important to remember that the Affordable Care Act enacted in the 111th Congress was perhaps the most substantial piece of deficit reduction in decades, lowering the projected deficit in the decade following conventional 10-year budget windows by more than $1 trillion and prompting massive downward revisions to long-run projections of public debt.

2. Sequentially for this paragraph:

($109) x (1.4) = $153

($153) / ($15,899) = 1.0%

($109) x (0.32) = $35

($109) x (0.25) = $27

($35) / ($153) = 22.9%

($27) / ($153) = 17.6%

(($109/2) x (1.4) + ($109/2) x (0.25)) = $90

($90) / ($153) = 58.9%

Note that we use Moody’s Analytics Chief Economist Mark Zandi’s fiscal multipliers, which have the advantage of being policy specific, but are robust to estimates by CBO, the Council of Economic Advisers, and the International Monetary Fund, among others (see my colleague Josh Bivens’ blog post for more on robustness of multipliers).

Appendix Table A2

Part of this “everything” was the efforts of the new administration to end the Great Recession and restore the economy back to full health. From the start, the GOP sought to block measures that a wide swath of economists agreed would provide help to boost the economy and bring down unemployment. This obstructionism has been a constant theme throughout the past four years, and it continues today.

Congressional Republicans have made it clear that they intend to use every bit of leverage they can to force cuts to domestic spending in the coming year. This leverage includes threats to not raise the statutory debt ceiling and/or force a federal government shutdown after March 27, when the standing appropriations continuing resolution (CR) expires. This, of course, would represent the long-promised repeat of the spring and summer of 2011, when congressional Republicans secured over $500 billion in domestic spending cuts in CR fights and another $2.1 trillion in spending cuts in exchange for incrementally raising the debt ceiling by an equivalent amount—better known as the Budget Control Act (BCA) of 2011.

The BCA cuts have already done damage, and will all-but-surely slow growth in the rest of 2013 as well. The various components of the BCA accounted for about one-third of the total fiscal drag exerted by the major components of the “fiscal cliff” that was facing Congress ahead of the lame duck budget deal. And the components of the BCA account for 48 percent of the remaining fiscal drag unaddressed by the deal—a drag that is poised to shave 1.0 percentage point from real GDP growth in 2013. House Republicans have voted to replace the Defense cuts contained within the sequester—again rapidly approaching, following its postponement to March—in it with deeper domestic spending cuts, leaving a drag of 0.8 percentage points from the BCA for 2013, all while threatening to use the debt ceiling and CR as leverage to get their way.

If this ideologically driven objective of deeply cutting spending is met, this will represent just one more way that the GOP Congress has managed to delay full recovery from the Great Recession. The evidence continues to pile up that that these spending cuts, forced on a still-depressed economy, can easily throw the nation back into an outright recession and prolong the nation’s economic misery.

Is this an overly harsh read on the motivations of GOP members of Congress? Not at all. Motivations aside—regardless of whether they deeply believe that their ideological goal of reducing government spending will help the economy or whether they think that a slowed economy will simply help their own electoral prospects—the facts are simply that congressional Republicans have consistently hamstrung efforts that a large consensus of economists agree would have provided crucial help in lowering American unemployment. Specifically, they have objectively weakened the American Recovery and Reinvestment Act (ARRA), repeatedly filibustered routine extensions of emergency unemployment benefits, blocked aid to state governments, filibustered infrastructure investment, used extreme legislative vehicles like refusing to follow precedent on the typically pro forma votes to raise the debt ceiling to extract more economically damaging government spending cuts, blocked passage of a majority of the American Jobs Act (AJA), demanded counterproductive offsets to fiscal stimulus, and attacked the Federal Reserve’s expansion of the monetary base and other policy responses intended to lower unemployment. What follows is an abbreviated chronology.

The American Recovery and Reinvestment Act (111th Congress)

It may seem odd to bring up ARRA in the context of obstructionism—after all, ARRA actually passed and really was the largest piece of discretionary fiscal policy stabilization ever to emerge from Congress. But it’s useful to remember that the ARRA passed without one single vote from a GOP Representative, and with only 3 of 41 GOP Senators voting for it (and one of these three—Arlen Specter—was a Democrat within the year, in large part because of this vote).

So, they tried their mightiest to obstruct it. Even the opportunity cost of just getting these GOP Senate votes was expensive. These votes were needed to push past the filibuster-proof 60 vote threshold—and it’s a slam-dunk that ARRA would have been successfully filibustered without them. The price tag of getting these votes was nearly $30 billion in school construction funds stripped out of the bill at the insistence of Sen. Susan Collins (R-Maine), one of the three GOP votes in the Senate. These funds would have supported roughly 250,000 additional jobs. Further, the final version also included the nearly $70 billion cost of a one-year extension of the Alternative Minimum Tax (AMT) “patch”—a provision that provided no stimulus at all, since it was done literally every single year, but which was included to woo another GOP Senator, Olympia Snowe. If this amount could instead have been spent on productive stimulus, it could have created roughly 750,000 jobs. In short, just luring the minimal GOP votes needed to pass ARRA in the Senate likely kept it from supporting or creating nearly a million more jobs than it did.

Filibusters of unemployment insurance and routine economic support (111th Congress)

Securing 60 votes for ARRA in the Senate was necessary because virtually every piece of economically supportive legislation has effectively been filibustered since the start of the 111th Congress (in Jan. 2009). In Feb. 2010, Senate Republicans blocked cloture on the HIRE Act (H.R. 2847) and managed to strip down stimulus provisions, paring the bill to about $15 billion in poorly targeted economic stimulus; the bill originated as the House-passed Jobs for Main Street Act, a $75 billion package of infrastructure investments, aid to state governments, and other job creation measures. That same month, Sen. Jim Bunning (R-Ky.) filibustered the House-passed Temporary Extension Act (H.R. 4691), which would have extended emergency unemployment benefits, COBRA health insurance subsidies for the unemployed, and expanded Small Business Administration loan guarantees, among other provisions. In March 2010, Sen. Tom Coburn (R-Okla.) filibustered the Continuing Extension Act (H.R. 4851), a similar package of economic stimulus targeted toward the unemployed. In June 2010, Senate Republicans repeatedly blocked cloture votes on the House-passed American Jobs and Closing Tax Loopholes Act (H.R. 4213), which would have provided infrastructure investment incentives, business tax credits, a summer youth employment fund, and a six-month extension of emergency unemployment benefits, among other provisions. By July 2010, more than 2.5 million workers had lost unemployment benefits for at least a spell of time because Senate Republicans continued to block the Emergency Unemployment Compensation (EUC) program, objecting to typically pro forma emergency designations for routine economic support (i.e., demanding offsetting “pay-fors”).

Discretionary spending cuts (112th Congress)

At the start of the 112th Congress, incoming Speaker of the House John Boehner (R-Ohio) pledged to cut non-security discretionary (NSD) back to 2008 levels, which entailed decreasing spending by roughly $100 billion (22 percent). Senate Republicans had filibustered an omnibus appropriations bill in Dec. 2010, leaving the U.S. government running on a ”continuing resolution” holding discretionary spending at current levels—an increasingly common practice in an era where partisan divides keep the full congressional budgeting process from functioning. In Feb. 2011, House Budget Committee Chairman Paul Ryan (R-Wis.) and Appropriations Committee Chairman Hal Rogers (R-Ky.) proposed a budget that would reduce discretionary spending by a prorated $58 billion for the remaining 7 months of fiscal 2011, relative to the president’s budget request (a 21 percent cut on an annualized basis). After negotiating a series of shorter continuing resolutions—all of which cut spending levels—and with a government shutdown looming imminent, House Republicans and the administration compromised on a $1.049 trillion discretionary spending level for fiscal 2011, cutting NSD spending by $38 billion relative to fiscal 2010 levels. Much of the cuts for 2011 were phantom savings (e.g., rescinding funds that would never have been spent), but contrary to too much discussion of these phantom cuts, they had real consequences by substantially reducing the discretionary spending baseline from which subsequent cuts were made because the Congressional Budget Office (CBO) indexes discretionary spending levels for inflation. CBO’s Jan. 2011 budget outlook showed the baseline for discretionary outlays revised downward by $351 billion over fiscal 2011–2021 because of decreased funding levels in continuing resolutions, with an additional $40 billion downward revision in their March 2011 baseline update. The full-year appropriations bill reduced projected discretionary outlays by an additional $122 billion over fiscal 2011–2021. Cumulatively reducing the baseline for discretionary spending by some $513 billion resulted in deeper and more damaging spending cuts extracted from last summer’s debt ceiling fight. In short, the GOP had much more success than is commonly recognized in forcing large spending cuts in the first half of 2011.

Hijacking the debt ceiling and extracting the Budget Control Act (Summer 2011)

In 2011, Congressional Republicans refused to undertake the customarily pro forma increase in the statutory debt ceiling, arguing that they would only vote to do so if coupled with much deeper spending cuts than extracted from the CR budget negotiations. And as the Washington Post detailed at great length, this economic hostage-taking was premeditated rather than spontaneous Washington dysfunction, a “natural outgrowth of a years-long effort by GOP recruiters to build a new majority and reverse the party’s fortunes.”

The Obama administration unfortunately acquiesced to the GOP demand that each dollar increase in the debt ceiling be matched with a dollar reduction in spending. To be clear, the GOP members of Congress were not seeking deficit reduction, they were seeking spending cuts. Congressional Republican leadership abandoned negotiations over a deficit reduction “grand bargain,” first with Vice President Biden, then from negotiations with President Obama. To be clear, we do not think such a “grand bargain” would have been prudent economic policy, but this narrative does belie GOP claims to be motivated by concerns over large deficits.

Two-and-a-half months after the Treasury Department declared a “debt issuance suspension period” of unconventional cash-management tools to avoid a default on U.S. debt, the Budget Control Act (BCA) was enacted on Aug. 2, the last day Treasury could avoid defaulting. The BCA proved the second greatest budgetary impediment to recovery in the so-called “fiscal cliff,” as explained in this briefing paper. We estimated that the first phase of discretionary spending caps would shave 0.3 percentage points from real GDP growth in 2012 and lower employment by 323,000 jobs, as detailed in this briefing paper. Ratcheting down discretionary spending caps will shave 0.4 percentage points from real GDP growth in 2013, decreasing employment by 529,000 jobs relative to pre-BCA law; should they take effect, the second phase of scheduled automatic sequestration cuts—which have been postponed until March—will slow growth by an additional 0.6 percentage points and reduce employment by 660,000 jobs in 2013. Again, GOP success in using all legislative leverage at their disposal to force spending cuts has (and will continue) to slow economic recovery.

Blocking the American Jobs Act (Fall 2011)

In Sept. 2011, Obama proposed the AJA, a $447 billion package of infrastructure spending, unemployment benefits, funds for rehiring teachers and first responders, and tax cuts for households and businesses, among other provisions. Senate Republicans filibustered the full $447 billion AJA, and subsequently blocked smaller subsets of the AJA that would have put a dent in the unemployment rate, notably funds to rehire teachers and first responders as well as $56 billion worth of infrastructure investments. All variations of the AJA would have been financed with surtaxes on millionaires—meaning that long-run deficits would actually be reduced by the AJA. President Obama proposed another variation of the AJA in his fiscal 2013 budget, which we estimated would have lowered the unemployment rate roughly half a percentage point. Congress only enacted a scaled back extension of the payroll tax cut (the AJA would have expanded it for workers and employers) and EUC (Congress unwisely lowered the maximum duration of benefits in high unemployment states from 99 weeks to 73 weeks in the midst of a long-term unemployment crisis). We estimated that full passage of the AJA would have boosted real GDP growth by 1.4 percentage points and employment by more than 1.6 million jobs by the end of 2012, relative to the scaled back extension of ad hoc stimulus that made it through Congress.

Demanding offsets and “pay-fors”

As noted above, the AJA was scuttled by Senate Republicans’ demands that stimulus spending be offset to make it deficit neutral—but they demanded this offset come only in the form of spending cuts, not tax increases. All economic evidence shows that this is a deeply counterproductive demand. Nonetheless, Senate Republicans proposed paying for an extension of the payroll tax cut by cutting federal employees’ pay and reducing federal employment by hundreds of thousands of jobs—both of which would reduce aggregate demand. An additional $231 billion in spending cuts would have been layered on top of the discretionary spending cuts Republicans extracted with the BCA—to more than pay for a $120 billion tax cut. (The purpose of a pay-for is to offset the cost of a policy, not its beneficial impact.) The payroll tax cut was eventually extended with an emergency designation (i.e., deficit-financed), but other demands for “offsets” will take a toll on aggregate demand. In 2010, a $26 billion package of aid to state governments for rehiring teachers and helping states pay for Medicaid (H.R. 1586) was partially paid for by rescinding $12 billion from the Recovery Act’s expansion of the Supplemental Nutrition Assistance Program (SNAP, or food stamps). Food stamps, by the way, yield the highest fiscal multiplier of any fiscal stimulus, according to Moody’s Analytics chief economist Mark Zandi. Most recently, House Republicans have proposed replacing sequester cuts to the Department of Defense—part of the Republicans’ price for raising the debt ceiling in 2011—with even deeper domestic spending cuts; the Spending Reduction Act of 2012 (H.R. 6684) would have replaced $98 billion of defense cuts with $334 billion in nondefense discretionary and mandatory spending cuts as well as revenue.

Hamstringing monetary policy

The congressional GOP does not have a direct means of obstructing expansionary monetary policy, of course, but their constant strategy in recent years has been to decry any attempt by the Federal Reserve to boost economic activity as dangerously inflationary. Some have even gone so far as to argue that the Fed should have its mandate changed to target only price stability and not full-employment. Needless to say, this claim that the Fed has been recklessly aggressive in trying to lower unemployment is clearly wrong. The Fed has actually been more aggressive than other macroeconomic policymakers in trying to address the crisis, it’s true. But that’s a very low bar, and the congressional GOP have consistently tried to push back against even this too-mild effort by the Fed to engineer a rapid recovery. While it remains an open question about just how effective more-determined Federal Reserve policy could be to boost recovery, there is no question that the risks of pushing harder on the monetary policy lever to restore growth are deeply asymmetrical: there are huge upsides if it effectively spurs growth and very little downsides if it fails.

Conclusion

Concern that the GOP Members of Congress have a vested interest in slowing economic recovery has been brewing for quite some time. Speaking at Cuyahoga Community College ahead of the election, former President Bill Clinton accused congressional Republicans of deliberately trying to keep the unemployment rate elevated for political gain. Clinton’s remarks echoed similar comments made by Sen. Chuck Schumer (D-NY) at the Economic Policy Institute during the 2011 debt ceiling fight:

“[W]e need to start asking ourselves an uncomfortable question — are Republicans slowing down the recovery on purpose for political gain in 2012? Senator McConnell made it clear last October that his number one priority, above everything else, is to defeat President Obama. And now it is becoming clear that insisting on a slash-and-burn approach may be part of this plan — it has a double-benefit for Republicans: it is ideologically tidy and it undermines the economic recovery, which they think only helps them in 2012.”

For those closely watching the budgetary and economic policy fights of the past four years, it’s pretty hard to refute the analysis of Clinton and Schumer.

Viewed through the proper lens of avoiding premature austerity instead of compromising over tax policy for the top 2 percent of earners, Congress predictably failed to adequately moderate the pace of deficit reduction; short of sharply reorienting fiscal policy to accommodate accelerated recovery, U.S. trend economic growth will continue decelerating into 2013—slowing to anemic growth insufficient to keep the labor market just treading water.1 Absent substantial (seemingly remote) additional spending on public investment and transfer payments, the labor market will almost certainly deteriorate this year, regardless of what happens with sequestration and the pending debt ceiling fight. 

I recently explained that the fiscal “cliff,” or rather, fiscal obstacle course debate was intrinsically fixated on maintaining anemic growth versus falling into a recession and deeper depression, not moving toward full recovery. As a rough compass, policymakers need to target real GDP growth above 2.2 percent (the Congressional Budget Office’s estimate of real potential economic growth over 2012–2022) if this depression is to eventually be ended. Trend economic growth for the first three quarters of 2012 registered only 2.1 percent annualized real GDP growth, which is below this benchmark, meaning that sustaining current economic performance would fail to make progress toward restoring full employment. And this budget deal—indeed expiration of the payroll tax cut alone—guarantees that current economic performance will not be sustained.

If all the major components of the fiscal obstacle course were “turned off,” (i.e., scheduled spending cuts repealed and tax increases prevented), we projected that real GDP would grow 3.1 percent in 2013. If, on the other hand, the current policy baseline were adhered to (in which the payroll tax cut and emergency unemployment benefits were assumed to expire and discretionary spending caps continue ratcheting down), we estimated the economy would decelerate to 1.4 percent real growth. And if the legislated fiscal contraction fully materialized (adhering to the current law baseline), CBO forecasted that real GDP would contract 0.5 percent in 2013.2 So how does the enacted deal stack up?

Problematically, the budget deal shrinks the projected budget deficit for 2013 relative to current policy, whereas the economic challenge at hand was moderating the pace of deficit reduction. The biggest economic drags in the fiscal obstacle course were the scheduled expiration of ad hoc fiscal stimulus and the Budget Control Act (BCA) of 2011, but these were only partially mitigated. What follows is an overview of major fiscal headwinds still pending for 2013:

• First and foremost, the expiration of the payroll tax cut is projected to reduce disposable income by $115 billion, shaving 0.9 percentage points from real GDP growth and lowering employment by nearly 1.1 million jobs relative to 2012 fiscal policy.
• The sequester was delayed for only two months, leaving a drag of 0.6 percentage points of real GDP if it materializes for the remainder of the year, or if the sequester is replaced with other spending cuts of a comparable magnitude (e.g., House Republicans voted to replace sequester cuts to the Department of Defense with deeper domestic cuts). This would mean a loss of 660,000 jobs relative to 2012 fiscal policy.
• The phase-one BCA discretionary spending caps will ratchet down, shaving 0.4 percentage points from real GDP growth and reducing employment by roughly 530,000 jobs relative to pre-BCA law.
• The Emergency Unemployment Compensation (EUC) program was extended, but only for a maximum duration of 73 weeks and to the cost of $30 billion in 2013, down from $39 billion in inflation-adjusted outlays for 2012 (when a maximum duration of 99 weeks was in effect for much of the year). Relative to 2012 fiscal policy, this implies a drag of 0.1 percentage points and 100,000 fewer jobs.
• The partial expiration of the upper-income Bush-era tax cuts (see Josh’s post) will shave less than 0.1 percentage points from real GDP growth and reduce employment by roughly 80,000 jobs, relative to 2012 fiscal policy.
• Downward revisions to discretionary spending caps and offsets paying for continuation of the Medicare “doc fix” would exert a slight additional drag.

Relative to fully mitigating the obstacle course components, these remaining drags imply 2.1 percentage points shaved off real GDP growth and more than 2.4 million fewer jobs in 2013. This suggests real GDP growth just above an anemic 1.0 percent for 2013. Relative to the 1.4 percent real growth we projected under current policy, the unaddressed bulk of pending sequestration cuts and the slight drag from partial expiration of the upper-income tax cuts exceeds the boost from continuing emergency unemployment benefits for up to 73 weeks. Even if the sequester is fully repealed without offsets—a best case policy scenario, but seemingly unlikely—real GDP growth of roughly 1.6 percent would be expected. Regardless, real growth rates anywhere in the range of 1.0 percent to 1.6 percent for the full year suggest deterioration in the already distressed labor market.

This debate was always about averting a recession in favor of maintaining anemic growth rates. That may have been accomplished by the budget deal, although much uncertainty surrounds sequestration and the statutory debt ceiling. But this bar for political horse-trading was always set appallingly low. The United States is still mired in a severe jobs crisis, and it’s a safe bet this jobs crisis intensifies in 2013 because of premature budget austerity and policymakers’ abdication of promoting full employment.

Endnotes

1. The decline in the headline unemployment rate masks that the labor market has largely been treading water. Ceteris paribus, adding 3.9 million unemployed workers “missing” from the labor force (for cyclical as opposed to structural reasons), the headline unemployment rate would be roughly 10 percent.

2. Growth projections for 2013 are all measured from 4Q2013 relative to 4Q2012, extrapolated from CBO’s Aug. 2012 economic baseline. CBO’s economic baseline reflects current law, and current policy and various policy scenarios are modeled from our à la carte menu of the major fiscal obstacle course components’ economic drags as well as CBO’s cost estimate of the American Taxpayer Relief Act (H.R. 8).

We tried to describe this problem and even put numbers to each of the main components of the “fiscal cliff” in a September report. Some key punchlines of this analysis were that the problem posed by the “fiscal cliff” was that deficits would shrink too quickly in the coming year, and that while the Bush-era tax cuts for upper-income households were the most politically contested part of the cliff, it was the automatic spending cuts (including the end of extended unemployment insurance benefits) and the payroll tax increase that were, by far, the most economically damaging parts of the cliff. In fact, the fate of upper-income tax rates was almost irrelevant, one way or the other, to economic recovery in the coming year.

So what did Congress do in this deal? They mostly monkeyed around with upper-income tax rates. Which leaves the large bulk of the fiscal contraction set for the coming year still in place, or just temporarily delayed. In short, it is very odd to describe what happened over this long weekend as a deal that addressed the “fiscal cliff.” 

Blow-by-blow analyses of the deal can be found elsewhere, but this is the summary:

• The Bush-era ordinary tax rates were allowed to lapse for incomes more than $450,000 per year
• Some mild (but useful) base-broadening was done that would increase taxes starting on households with more than $250,000 in income
• Dividend tax rates were permanently extended at the Bush-era levels
• The estate tax was permanently set at levels far more generous to inherited wealth than before the Bush era tax cuts
• The Alternative Minimum tax (AMT) was permanently indexed to inflation to keep it from creeping down the income scale
• Some tax cuts targeted to low– and moderate-income households, as well as those paying for college tuition, were extended for five years (not permanently)
• Extended unemployment insurance benefits were passed for another year

Further, the automatic  spending cuts known as “the sequester” have been postponed for two months, while the two percentage-point cut in payroll taxes that was in effect for the past two years has been allowed to lapse.

What should we think about all of this?

First, the pluses. Unemployment insurance benefits were extended. Given that the labor market remains weak, this is both compassionate and intelligent economic policy. The sequester has at least been postponed. And we actually will be raising more money from higher-income households going forward—and this will not slow recovery and will allow more resources for necessary public investments and social insurance programs in the future. In the analogy put forward by Chris Hayes, our policy muscles that allow tax increases, which seemed irretrievably atrophied in the last decade, finally are getting some activity.

Next, the minuses. It has done very little to deal with the real problem of fiscal contraction in the coming year, making the recovery much slower. If the sequester is canceled in two months, or even if it is canceled but “paid for” with tax increases on high-income earners (or in a dream world where policy that was efficient and popular actually became law, by something like a financial transactions tax), then much of this fiscal drag could still be averted. But it hasn’t been yet—and the prospect of paying for it with a reasonable estate tax seems to have sailed because of this deal, which is a real shame. The permanent enshrinement of low dividend tax rates is bad policy, and looks especially ugly when paired with tax breaks for lower-income households that are not permanent, but sunset in five years. On the bright side, “permanent” really just means “until another Congress changes its mind,” so there’s that to hope for. And, the bright line on revenue increases—that Bush-era tax rates would phase out on income more than $250,000—was broached, and the income limits on these higher rates was raised. Apparently the “middle-class” that Congress is always pledging to protect now starts at $450,000 in taxable income.

And the big minus is that the verdict on the “sequester” will be decided just as the nation hits the statutory debt ceiling. GOP members of the House of Representatives clearly are hoping this will give them leverage to force their own agenda. And it worked before. Which means that this time, the Obama administration needs to be deadly serious about not negotiating over the debt ceiling.

So the big story is that very little has actually been decided. On the one hand, lots of revenue has been lost relative to a scenario that saw all tax cuts for households making more than $250,000 phasing out (and most people, including me, thought that this really would be the starting point of negotiations). And only about $40 billion of effective stimulus that was set to fade away in 2013 was definitively clawed back (the unemployment insurance extensions plus refundable tax cuts passed in the American Recovery and Reinvestment Act that were extended), while about $120 billion in decent stimulus (the payroll tax cut) just seems completely off the table now. On the other hand, one-sixth of the automatic spending cuts called for under the sequester in 2013 have been deferred (and more action might be taken in the next two months) and tax rates for very high income Americans actually went up.

Between the payroll tax cut and the sequester, as well as the failure to undo the first discretionary spending caps negotiated under last year’s Budget Control Act (BCA), well over half of the fiscal drag for 2013 that was actually up for negotiation1 has yet to be deactivated. This means that relative to current policy, we will have roughly 1.6 million fewer jobs by the end of 2013 than if these had been definitively extended or replaced with equivalent stimulus.

What do we know for sure? The “fiscal cliff” was definitively not averted. Action wasn’t taken until after Jan. 1. Which (as we always said) was just fine—obsessive worrying about that date displayed a real ignorance about the economics of this situation. Worse than missing the date, of course, is that the fiscal contraction in the coming year wasn’t actually addressed in a definitive way. And another cliff—one that will see the sequester and the debt ceiling come to head—is in our future.

Endnotes

1. Basically, everything in Table 1 of this paper except for the AMT patch, the business tax extenders, and the Medicare “doc fix,” which are dealt with every single year by Congress, slow economy or not. Table 1 without those routine extensions is pasted in below, with the fiscal drag yet to be addressed circled.