The debt-ceiling debate has been dominated by warnings about what might happen to the economy if Congress fails to come to an agreement. But what if all goes well? What happens to the economy if and when Congress reaches a deal that sharply cuts spending amidst a weak and uncertainty recovery?
The constant disagreements over the various proposals have masked a broader agreement on the need for an extended period of deficit reduction — “an era of austerity,” as Democratic Minority Leader Nancy Pelosi declared Monday. Both John Boehner and Harry Reid have proposed slashing $1.2 trillion in federal discretionary spending over the next 10 years and arming a bipartisan commission with procedural protections if they can agree on a plan with an even larger suite of cuts.
In recognition of the economy’s continuing weakness, both plans are likely to “backload” their cuts. According to the Congressional Budget Office (pdf), Boehner’s initial proposal would cut just $4 billion in discretionary spending during fiscal 2012, but the number would quickly ramp up in the years thereafter: $20 billion in FY 2013, $58 billion in FY 2014 and so forth.
But conservative concern over whether future congresses will follow through on the promised cuts is forcing Boehner to revise his plan and frontload more of his savings. And neither plan sustains the expansions of unemployment insurance or the payroll tax cut that have helped boost the economy over the past year. So the net effect of both plans will be to yank support out from under an economy that’s still teetering.
“The problem is that aggregate demand is very weak from consumers and businesses. If government cuts spending in the near term, raises taxes in the near term, that would be a drag on growth,” says Gus Faucher, director of macroeconomics for Moody’s Analytics. He distinguishes “good” and “bad” deficit reduction: The good kind would reduce government spending when the economy is stronger, which would reduce long-term interest rates and free up more money for the private sector to spend and invest. By contrast, the bad kind of deficit reduction “would focus on cutting spending right now, while the economy is still weak.”
Similarly, authorities such as the International Monetary Fund have dismissed (pdf) the idea that austerity measures would help an economy such as the United States’ in the short term, pointing out that few cases exist where sharp cuts led to fast growth in countries where employment was robust, interest rates were high (so the monetary authorities could compensate for the cuts), and exports were strong — conditions that don’t apply to the United States. More normally, they concluded, “a fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point.”
The United Kingdom’s austerity experiment — which is perhaps the best example we have of an economy attempting such a policy in this economic context — has yielded dubious results. The country’s GDP grew by an anemic 0.2 percent in the last quarter, signaling a weaker economy than anyone had thought. Though the UK’s deficit-reduction effort includes not only massive spending cuts but also significant tax increases — in contrast to what’s being proposed here — the contraction began even before the tax hikes took effect.
In theory, Congress could craft a deal that would combine short-term fiscal support with long-term cuts to aid America’s still-struggling economy, but politically speaking, that won’t happen. Which means that though not reaching a deal will do enormous damage to the economy, the odds are good that reaching a deal will cause us harm, too.