- The drag implied by going over the cliff would subtract about $1tn from growth in the 18 months from January 2013.
- In a liquidity trap, with interest rates stuck at zero, there is no offset to the fiscal drag.
- Congress should specify a decade-long program to stabilize and then reduce the debt-to-GDP ratio, without hurting growth.
As the deficit reduction debate drags on, talk is growing in Washington about allowing the US to go over the fiscal cliff, triggering $600bn of spending cuts and tax increases in the new year. Some are suggesting that doing so would not be too damaging to the economy. Or even that it would be a good tactical move, providing the new Congress with an incentive to reach a significant budget accord.
Such thinking seriously underestimates the cost of going over the cliff. The willingness to contemplate failure is perhaps understandable. The Congressional Budget Office has estimated that while the economy would shrink at an annualized rate of 1.3 per cent during the first half of next year were the cliff not averted, growth would rebound to 2.3 per cent in the second half of 2013.
But the CBO estimates are far too conservative. The fiscal drag implied by going over the cliff would subtract about $1tn (6.3 per cent of gross domestic product) from projected growth over the 18 months from January 2013. Given the consensus forecast for 2 per cent growth next year, that leaves a growth rate of -2.2 per cent for 2013. This calculation is consistent with estimates reported in October by the IMF.
An extant American liquidity trap explains why the recession would be so severe. Such a trap exists when interest rates are frozen at zero and cannot fall. It magnifies the negative impacts of austerity. Absent the trap, the drag on GDP from tighter fiscal policy is usually mitigated by falling interest rates. Interest rates tend to fall, as household and business incomes drop and demand for money and credit shrinks. Lower interest rates then boost private sector spending, partially offsetting the fiscal drag from higher taxes and government spending cuts.
But in a liquidity trap, with interest rates stuck at zero, there is no offset to the fiscal drag. In technical terms, the negative multiplier is larger than usual. The IMF has produced evidence that negative fiscal multipliers have indeed been larger than expected since the start of the financial crisis, which has coincided with interest rates falling close to zero and economies stuck in liquidity traps.
The enhanced fiscal drag tied to austerity programs such as those in Greece, Portugal and Spain must have come as a nasty shock. During 2010 and 2011 some European central bankers were arguing that the boost to confidence from cutting deficits would mean that austerity might actually stimulate those economies. It did not. Instead, in the absence of interest rate reductions, the drop in incomes engendered by austerity so depressed tax receipts that the ratio of government debt-to-GDP has increased in southern Europe.
Three lessons emerge from the larger negative fiscal multiplier implied by America's liquidity trap and from Europe's sad experience with austerity. First, do not even think about going over the fiscal cliff. Even a "half cliff" - fiscal drag of 2.1 per cent of GDP - would put the US economy in a recession for all of 2013. Second, don't expect the Federal Reserve to offset fiscal drag. It can't. Conventional monetary policy cannot stimulate spending, because the Fed cannot lower interest rates. Nor can quantitative easing because it is being undercut by a growing demand for liquidity as businesses and households confront uncertainty, ranging from fiscal cliff negotiations to healthcare revisions and a possible collapse of the euro.
The third lesson applies to the design of fiscal tightening. If averting the fiscal cliff requires a Republican concession on tax rates for "the rich" in exchange for entitlement reforms, the rise in such rates should be minimized - to
2 percentage points at most - by simultaneously reducing regressive tax allowances. Taxpayers with incomes of more than $250,000 will already start paying an extra 3.8 per cent Medicare tax on all income from January 1 2013.
Then during 2013, Congress should specify a decade-long program to stabilize and then reduce the debt-to-GDP ratio, without hurting growth. That program should include entitlement reform and fund phased reductions of marginal tax rates by further reducing allowances. Once such a program is passed, talk of "unsustainable" deficits should cease, confidence rise, and the US move back to stable, non-inflationary growth of 3 to 3.5 per cent.