Where is America’s economy headed in 2013? Will therecovery continue at its frustratingly slow pace? Or will it accelerate as thehousing sector rebounds, bank lending expands, household balance sheetsimprove, and state and local government budgets strengthen?
With economic headwindsdissipating, the United States’ prospects for faster GDP growth appearpromising. But there is also a significant risk that a large and unnecessarydose of fiscal austerity will weaken demand, undermine confidence, and tip theeconomy back into recession.
Since 2010, annual GDPgrowth has averaged about 2.1%, less than half the average of recoveriesfrom previous US recessions over the last 60 years. Slow GDP growth has meantslow employment growth. The unemployment rate remains about two percentagepoints higher than what most economists consider consistent with a fullrecovery, and the labor-force participation rate is hoveringnear historic lows. The economy is still operating far below its potential: GDPis about 6% below what the economy is capable of producing at full capacitywithout higher inflation.
Tepid growthreflects weak demand. Housing prices are rising, and, while residentialinvestment is increasing, it remains depressed as a share of GDP. Householdshave cut their debt and rebuilt their balance sheets, but the large loss inhousehold wealth, weak growth in wages and income, the concentration of mostincome 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 securitiesfar below their historical average in both nominal and real terms, the economiccase for temporary fiscal measures to boost demand is compelling. Yet the USCongress, spearheaded by Republicans in theHouse of Representatives, appears to be heading in the opposite direction, sofar failing to agree on a deal to protect the economy from much, if not all, ofthe $600 billion in tax increases and spending cuts – the so-called fiscalcliff – scheduled to take effect in 2013.
Confusion, fear, ideology, and electoral self-interest allplay a role in the readiness of many members of Congress – despite warningsfrom the Federal Reserve, the Congressional Budget Office, and most privateforecasters – to make such an egregious mistake.
sFirst,confusion.The US faces two distinct fiscal challenges: the tax increases and spendingcuts that threaten to derail the economy in 2013; and a long-term structuraldeficit that is likely to mean higher interest rates, less investment, andslower growth once the economy has recovered and the output gap hasdisappeared. Unlike the fiscal cliff, the structural deficit problem is not imminent: contrary to deficit hawks’ dire warnings, the US does not face a time-sensitivedebt crisis.
Although US federal debt is projected to rise at anunsustainable rate in the long term, the right solution is not fiscalbelt-tightening now, but rather a credible plan to stabilize the debt/GDP ratiogradually as the economy recovers. Indeed, as Fed Chairman Ben Bernankerecently observed, preventing a severe fiscal contraction in 2013 will boostgrowth, reduce the near-term deficit, and help to solve the long-term debtproblem.
Second, fear. The US government currently can borrow at historicallylow interest rates. As a result of the financial crisis, more risk-averseinvestors at home and abroad have increased their demand  for US Treasurysecurities. But what if investors lose confidence in the US government’sability or willingness to tackle its long-term debt problem and begin to fear adefault (either explicit or through rapid inflation)? The result could be aspeculative attack by “bond-market vigilantes,”triggering a sharp rise in interest rates, a dramatic fall in the dollar, or acombination of the two.
For three years, repeated warnings that such an attack isimminent 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 investorsignored Standard & Poor’s 2011 decision to downgrade US government debt, driving down yields even further.
Of course, Congress could spookinvestors and increase the likelihood of a bond-market attack by failing toraise the debt ceiling in 2013. But, absent that monumentalfolly, long-term interest rates are unlikely torise significantly as long as the Fed keeps short-term interest rates low –which it recently committed to do until unemployment falls to 6.5%. Congressthus has adequate time to develop a sensible long-term plan to stabilize thedebt without endangering the recovery.
Third, ideology. Some members of Congress are unwilling to vote forany tax increase, even as part of a compromise to avert the fiscal cliff or tostabilize the debt. More than 90% of House Republicans have signed a “no-taxpledge.” Other members champion the cause of a much smaller government andwelcome the deep spending cuts that are scheduled to take effect in 2013, even ifthey trigger a recession. For such members, ideological purity trumps economic logic.
Finally, electoral self-interest. The primary motivation of most membersof Congress has always been winning elections. But how this motivation affectstheir willingness to compromise has changed as a result of redistricting andthe growing polarization of voting districtsalong partisan lines. According to a recent analysis by Nate Silver, most House members nowcome from “hyperpartisan” districts in which the risk of losing to candidatesfrom the other party is small.
In such districts, members have little incentive tocompromise 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, ideologicallymotivated base, voting for such deals could trigger a primary electoralchallenge from within their own party. It was such self-interested Republicanmembers who rebuffed Speaker of the House JohnBoehner’s proposal to maintain current tax rates for all but those earning morethan $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 improvein the New Year.