Writing in The Washington Post recently, former Sens. Pete Domenici (R-N.M.) and Sam Nunn (D-Ga.) argued that enacting a bipartisan deficit reduction "grand bargain" could be instrumental in addressing the so-called "fiscal cliff" of legislated spending reductions and expiring tax cuts scheduled for the beginning of 2013. A grand bargain could theoretically mitigate the sizable pending fiscal headwinds, but a deal could also close deficits too quickly, pushing the economy into an austerity-induced recession. Nothing in their op-ed or the two grand bargains it references demonstrates how such a compromise could successfully clear the "fiscal cliff."
At its core the "fiscal cliff" represents the macroeconomic reality that budget deficits closing too quickly -- and public debt accumulating too slowly -- will push the U.S. economy back into recession. The scheduled spending cuts and tax increases comprising the legislated fiscal tightening are separable policies, all with varying budgetary costs and a wide range of economic impacts; we decomposed these à la carte in our recent paper, "A fiscal obstacle course, not a cliff." "Cliff" is a terrible metaphor, as it implies a binary choice, whereas each policy should be weighed on its economic impacts and budgetary costs. Government spending cuts are more economically damaging than tax increases, particularly for upper-income households and businesses, but tax increases will drag on growth to varying degrees. Collectively, the legislated fiscal tightening would shave 3.7 percentage points from real GDP growth, and the U.S. would experience a 2.9-percent contraction in the first half of 2013, pushing unemployment back above 9 percent, according to the Congressional Budget Office (CBO) -- if the legislated path is unexpectedly followed.
The two grand bargains Domenici and Nunn point to are the "Moment of Truth" report by National Commission on Fiscal Responsibility and Reform co-chairs Alan Simpson and Erskine Bowles and the "Restoring America's Future" report by the Bipartisan Policy Center's Debt Reduction Task Force, co-chaired by Domenici and former Office of Management and Budget and CBO director Alice Rivlin. But how would either of these plans or a similar congressional grand bargain help sustain recovery?
The only way a deficit reduction grand bargain could successfully navigate the fiscal obstacle course is if it substantially moderates the pace of deficit reduction while the economy remains depressed. But these two plans -- implied to be model remedies -- prematurely proposed austerity measures for a depressed economy, and the economy remains about as depressed today, relatively speaking. Fiscal contraction --particularly government spending cuts -- is highly damaging in a depressed economy, and U.S. economic output is currently depressed about $973 billion (5.8 percent of potential GDP) below potential economic output (the level of activity associated with full but non-inflationary levels of resource utilization; e.g., labor, industrial capacity, financial capital). When the Bowles-Simpson and Domenici-Rivlin reports were released in the fourth quarter of 2010, this "output gap" stood at 6 percent of potential GDP, roughly where it stands today. And as demonstrated across Europe, particularly by the United Kingdom, austerity cuts in a depressed economy are very much capable of counterproductively inducing a return to recession and deeper depression.
The Simpson-Bowles report in particular failed to acknowledge the prevailing economic context or budget for sustained economic recovery. One of the guiding principles of the co-chairs' plan reads: "Don't Disrupt a Fragile Economic Recovery." Their main recommendation in this section, however, was to delay spending cuts from December 2010 (when the report came out) until October 2011, at which point the unemployment rate was 8.9 percent -- far from the robust recovery that could accommodate deep fiscal retrenchment. Not only did their plan propose premature spending cuts, but it would not have accommodated the deficit-financed payroll tax cuts, emergency unemployment benefits and expansion of refundable tax credits that Congress enacted for 2011 and 2012. Earlier this year we calculated that this fiscal retrenchment would reduce economic output by 1.3 percent in fiscal year 2012 and 2 percent in fiscal year 2013, reducing nonfarm payroll employment by 1.6 million jobs in fiscal year 2012 and 2.4 million jobs in fiscal year 2013 (relative to the path Congress took and current budget policies).
The Domenici-Rivlin report earns higher marks for acknowledging the need for fiscal stimulus, but their policy prescription also fails to adequately moderate the pace of deficit reduction. They proposed completely waiving the Social Security payroll tax -- both the employer and employee sides -- for 2011, setting up an earlier "fiscal cliff" by pumping $641 billion of disposable income into the economy in 2011 and then immediately withdrawing it as spending cuts ramped up. Relative to their then-current policy baseline, spending cuts would be ratcheting up from $43 billion in the fiscal year just ended to $112 billion in fiscal year 2013, and tax increases -- less harmful per dollar, but contractionary nonetheless -- would have total non-interest deficit reduction ramping up to $324 billion for the fiscal year that just started (considerably more for calendar year 2013, the present focus of the fiscal obstacle course). And like Simpson-Bowles, emergency unemployment benefits -- among the highest "bang-per-buck" job creation measures and a crucial policy response to the persisting long-term unemployment crisis -- would have ended after December 2010, when the unemployment rate stood at 9.4 percent.
Domenici and Nunn are certainly correct that the U.S. faces a serious long-term fiscal sustainability challenge, one driven by rising health care costs, the aging of the baby boomers and inadequate revenue. But reading their op-ed, one would naturally and wrongly conclude that reducing deficits is the foremost challenge posed by the "fiscal cliff," whereas the challenge is reducing the pace of deficit reduction currently scheduled in order to sustain the recovery.
A grand bargain could successfully navigate the fiscal obstacle course, but only if it injects hundreds of billions of dollars of stimulative spending (e.g., unemployment benefits, infrastructure spending, aid to state governments and targeted tax cuts) into the economy for years to come and delays government spending cuts until the economy emerges from depression. However, that would require a substantial overhaul of either the Bowles-Simpson or Domenici-Rivlin reports. Contrary to what Domenici and Nunn imply, these are not shelf-ready templates for navigating the fiscal obstacle course; they fail the test of adequately moderating the pace of deficit reduction, even if their implementation were delayed to next year.