BERKELEY – Where is America’s economy headed in 2013? Will the recovery continue at its frustratingly slow pace? Or will it accelerate as the housing sector rebounds, bank lending expands, household balance sheets improve, and state and local government budgets strengthen?
With economic headwinds dissipating, the United States’ prospects for faster GDP growth appear promising. But there is also a significant risk that a large and unnecessary dose of fiscal austerity will weaken demand, undermine confidence, and tip the economy back into recession.
Since 2010, annual GDP growth has averaged about 2.1%, less than half the average of recoveries from previous US recessions over the last 60 years. Slow GDP growth has meant slow employment growth. The unemployment rate remains about two percentage points higher than what most economists consider consistent with a full recovery, and the labor-force participation rate is hovering near historic lows. The economy is still operating far below its potential: GDP is about 6% below what the economy is capable of producing at full capacity without higher inflation.
Tepid growth reflects weak demand. Housing prices are rising, and, while residential investment is increasing, it remains depressed as a share of GDP. Households have cut their debt and rebuilt their balance sheets, but the large loss in household wealth, weak growth in wages and income, the concentration of most income gains at the top, and a decline in labor’s share of national income to record lows continue to constrain consumption.
Under these circumstances, and with inflation subdued and interest rates on US Treasury securities far below their historical average in both nominal and real terms, the economic case for temporary fiscal measures to boost demand is compelling. Yet the US Congress, spearheaded by Republicans in the House of Representatives, appears to be heading in the opposite direction, so far failing to agree on a deal to protect the economy from much, if not all, of the $600 billion in tax increases and spending cuts – the so-called fiscal cliff – scheduled to take effect in 2013.
Confusion, fear, ideology, and electoral self-interest all play a role in the readiness of many members of Congress – despite warnings from the Federal Reserve, the Congressional Budget Office, and most private forecasters – to make such an egregious mistake.
First, confusion. The US faces two distinct fiscal challenges: the tax increases and spending cuts that threaten to derail the economy in 2013; and a long-term structural deficit that is likely to mean higher interest rates, less investment, and slower growth once the economy has recovered and the output gap has disappeared. Unlike the fiscal cliff, the structural deficit problem is not imminent: contrary to deficit hawks’ dire warnings, the US does not face a time-sensitive debt crisis.
Although US federal debt is projected to rise at an unsustainable rate in the long term, the right solution is not fiscal belt-tightening now, but rather a credible plan to stabilize the debt/GDP ratio gradually as the economy recovers. Indeed, as Fed Chairman Ben Bernanke recently observed, preventing a severe fiscal contraction in 2013 will boost growth, reduce the near-term deficit, and help to solve the long-term debt problem.
Second, fear. The US government currently can borrow at historically low interest rates. As a result of the financial crisis, more risk-averse investors at home and abroad have increased their demand for US Treasury securities. But what if investors lose confidence in the US government’s ability or willingness to tackle its long-term debt problem and begin to fear a default (either explicit or through rapid inflation)? The result could be a speculative attack by “bond-market vigilantes,” triggering a sharp rise in interest rates, a dramatic fall in the dollar, or a combination of the two.
For three years, repeated warnings that such an attack is imminent have flown in the face of the evidence: US Treasury securities remain a safe-haven asset for global investors, including risk-sensitive foreign central banks. Indeed, global investors ignored Standard & Poor’s 2011 decision to downgrade US government debt, driving down yields even further.
Of course, Congress could spook investors and increase the likelihood of a bond-market attack by failing to raise the debt ceiling in 2013. But, absent that monumental folly, long-term interest rates are unlikely to rise significantly as long as the Fed keeps short-term interest rates low – which it recently committed to do until unemployment falls to 6.5%. Congress thus has adequate time to develop a sensible long-term plan to stabilize the debt without endangering the recovery.
Third, ideology. Some members of Congress are unwilling to vote for any tax increase, even as part of a compromise to avert the fiscal cliff or to stabilize the debt. More than 90% of House Republicans have signed a “no-tax pledge.” Other members champion the cause of a much smaller government and welcome the deep spending cuts that are scheduled to take effect in 2013, even if they trigger a recession. For such members, ideological purity trumps economic logic.
Finally, electoral self-interest. The primary motivation of most members of Congress has always been winning elections. But how this motivation affects their willingness to compromise has changed as a result of redistricting and the growing polarization of voting districts along partisan lines. According to a recent analysis by Nate Silver, most House members now come from “hyperpartisan” districts in which the risk of losing to candidates from the other party is small.
In such districts, members have little incentive to compromise on bipartisan deals to address the country’s fiscal challenges, because failure to do so poses no threat to their re-election. On the contrary, especially for Republicans from districts with a strong, ideologically motivated base, voting for such deals could trigger a primary electoral challenge from within their own party. It was such self-interested Republican members who rebuffed Speaker of the House John Boehner’s proposal to maintain current tax rates for all but those earning more than $1 million per year.
The outlook for the US economy over the next few years hinges on what a deeply divided Congress decides. Right now, the prospect that they will make the right choices appears to be dim. Let’s hope the odds improve in the New Year.