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U.S. Fiscal Policy: Avoiding Self-Inflicted Wounds

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The United States and much of the world economy are still recovering from the devastating global recession that began in 2008. Sometimes crises happen that we cannot foresee or avoid.

But for the U.S. economy, serious risks could come at the end of this year from two potential self-inflicted wounds: the so-called “fiscal cliff” and the debt ceiling.

Let’s start with the fiscal cliff. In simple terms: if U.S. policymakers do nothing, a number of temporary tax cuts will expire and significant across-the-board spending reductions will kick in on January 1, 2013. The combined effect of these measures could result in a huge fiscal contraction, which would derail the economic recovery.

Why is this happening?

The payroll tax break, the Bush tax cuts (enacted in 2001 and 2003, and extended for two years at the end of 2010), as well as exemptions on the Alternative Minimum Tax are set to expire on January 1, 2013.

As for the cuts to government spending, it was agreed last summer that if the so-called “Super Committee” (a Congressional committee in charge of reducing the deficit) failed to approve a set of deficit-reduction measures, draconian cuts to defense and nondefense spending would take effect starting on January 1, 2013. Unfortunately, this threat did not work as envisaged—the Super Committee did not come up with any plan to reduce the deficit—and, as a result, the deep spending cuts are scheduled to kick in.

All in all, the cliff would remove about $700 billion from the U.S. economy next year—over 4 percent of GDP—with higher taxes contributing about three quarters of the total.

Is it really that bad?

Unfortunately, yes. The reason is that the U.S. economy is still slowly mending from the effects of the financial crisis.

The pace of the recovery is tepid, and unemployment remains elevated. The fiscal cliff would reduce growth to about zero on an annual basis in 2013, and the economy would most likely fall into a recession early next year. This is because the large tax increases would make consumers and businesses cut back on their expenditures, while the steep government spending cuts would also subtract from growth.

Furthermore, one traditional response—monetary policy action to lower interest rates—is hampered in the current environment because rates are already extraordinary low. And a weakening world economy would not be able to provide much support by buying U.S. goods and services.

What’s more, the negative impact of the cliff could start materializing even sooner, as uncertainty about what is going to happen early in 2013 might lead consumers, businesses, and government agencies to hold back their spending already this year, in anticipation of the cuts.

Yes, the U.S. needs to raise taxes and cut spending. But it should do so gradually, without sapping the economic recovery.

What can be done about it?

In principle, the fix is easy. A political agreement should be reached to ensure that tax increases and/or spending cuts are carried out by only a modest amount next year. Such an agreement would be all the more powerful in restoring confidence if it also included a credible plan to gradually raise taxes further and limit the growth of spending, so that the U.S. public debt stops growing faster than U.S. GDP.

In practice, of course, things are never easy, and there are significant differences across the U.S. political spectrum on how to reduce the deficit. But there is some common ground, and a number of bipartisan plans have been put forward.

The second self-inflicted wound

In late 2012 or early 2013 the U.S. federal government will again reach a statutory borrowing limit and will not be able to issue additional debt.

Why is this a problem?

First, because the federal government is spending considerably more than it collects in taxes; and second, because spending and tax collections are not synchronized.

As a result, if the ceiling is not raised in time, the government would need to cut spending drastically, curtailing important government functions, with detrimental effects on output and employment. And just the mere possibility that the government might  have to delay a payment on a bond could unsettle financial markets.

In the past, Congress has raised this limit on a regular basis. But last summer an acrimonious debate delayed the lifting of the debt ceiling until the very last minute. True, interest rates on Treasury bonds did not rise, as many had anticipated, but financial markets suffered, and uncertainty and a decline in faith in the political system took a toll on consumer and business confidence.

Unfortunately, it takes a lot of time to regain confidence and trust, but it takes one rash action to lose it. Wounds are painful and can take a long time to heal—but self-inflicted ones are easy to avoid.