This is the second of three posts looking at how the U.S. economy will do in 2013. Wednesday's installment examined the positive fundamentals that should drive a good year. Today's considers the political risks that could undermine those fundamentals. Friday's will look at international risks to the outlook.
The pieces are in place for 2013 to be a year of solid economic gains. But the big, dark cloud on the horizon is located right in the middle of the District of Columbia. Look for the building with the giant dome.
It is not simply that the federal government could mess up what should, by all rights, be a good year. It is that there are so many different ways that government policy could mess things up, a long menu of options for how things could go awry in Washington, with gloomy consequences across the United States. As economists at Goldman Sachs put it in their title to a research note last week, the story of the United States in 2013 is one of “Economics vs. Politics" — and the open question is: Which one will prevail, the improving economic fundamentals or the rapidly deteriorating political fundamentals?
These are the three major ways Washington could bungle the recovery.
Going off the cliff. This is the most scrutinized possibility, the one that has been widely analyzed (and, as of Thursday morning, at least, seemed like a growing possibility). It took a long series of events to arrive at the “fiscal cliff” of Dec. 31: the initial decision by the George W. Bush administration to agree to a finite end date for its tax cuts; an agreement by the Obama administration at the end of 2010 to extend those tax cuts and other measures for two more years; and a deal to raise the debt ceiling in August 2011 that put in place large and unpopular automatic spending cuts if no deficit reduction deal is reached. Now that all those deadlines have converged, to New Year’s Day 2013, the question is whether the key factions can reach a deal to avert an austerity crisis — too much deficit reduction, too soon.
If there is no deal, and the dive off the fiscal cliff happens with no resolution in sight, it means higher taxes on almost all Americans and dramatic cuts to both defense and other government programs. There would almost certainly be a recession.
If the nation goes fully off the fiscal cliff, and stays there, the Congressional Budget Office estimates it would amount to a drag on gross domestic product of 2.9 percentage points in 2013, and would increase the unemployment rate by 3.4 percentage points over its current 7.7 percent. It is a world in which the positive trends evident in the U.S. economy are overwhelmed by the giant sucking sound of fiscal austerity.
But while going off the cliff permanently is the most widely discussed way that government could blow the recovery, it’s not the only one. A deal could have its own perils.
A deal with too much austerity, too fast. Going off the fiscal cliff is probably not even the likeliest risk (though the odds are changing all the time). Another risk is that while there is a deal to avert the entirety of the cliff, it is a deal that calls for enough austerity in 2013 to seriously undermine the nation’s economic prospects.
There are already some hints that may happen: In negotiations that broke off last week, President Obama had reportedly conceded that a two-percentage point payroll tax holiday, put in place as a stimulus measure at the end of 2010, would be allowed to expire. That expiration alone would reduce the average working-class American’s after-tax pay by about $1,000 over 2013 — less money in people's pockets and less aggregate demand in the economy. The CBO estimates that the end of the payroll tax holiday, combined with an extension of unemployment benefits, could cost the economy 0.7 percentage points of growth and increase the unemployment rate by 0.8 percentage points over what it otherwise would have been.
That probably doesn’t mean a new recession, but is enough to turn what should be a better year for the economy into another year of muddling along.
Obama has pushed for other stimulus measures to counteract that drag, perhaps along the lines of new infrastructure spending. Congressional Republicans are opposed. How things shake out — and how rapid the onset of austerity is — will go a long way to determining how 2013 looks, even assuming a fiscal cliff resolution.
Debt ceiling hijinks. If the nation goes over the fiscal cliff, the results would be bad, but not catastrophic; we’ve had recessions before, we’ll have them again. But in late February or early March comes a deadline with even more at stake: The legally mandated cap on how much debt the Treasury can issue will become a binding constraint, setting the stage for the same messy negotiations that walloped financial markets and business confidence in the summer of 2011.
From an economic perspective, the thing that makes debt ceiling negotiations so perilous is the threat that Congressional Republicans are making -- in effect, to allow the U.S. government to default on its debts if they don't get their way on major spending cuts.
Whereas going over the fiscal cliff means only a recession, a failure to raise the debt ceiling would mean, potentially, a freeze-up of the global financial system and a serious blow to the credibility of the U.S. government as a safe place to park money. The 2011 standoff, even after being resolved, led Standard & Poor’s to downgrade the U.S. government’s credit rating, citing the “political brinksmanship” that led to that point.
Obama first proposed eliminating the current procedure, in which Congress must affirmatively vote to raise the debt ceiling, in favor of one where Congress must instead vote to override the president’s decision to raise it. Republicans rejected that, seeing the debt ceiling as a key lever of power with which to influence the course of government spending, despite controlling only one house of Congress.
This much is clear: If the debt ceiling standoff of summer 2011 recurs this winter, it won’t be good for business confidence, consumer confidence or financial markets.
Add these three things up, and the mission for leaders in Congress and the Obama White House is clear: Resolve the fiscal cliff, but in a way that phases austerity in gradually and carefully. And don’t play games with the debt ceiling. If they can navigate that tunnel, they will allow room for the private sector to have the good year that we’ve all been waiting for.