Over the Cliff We Go

The past two months’ run-up to the austerity bomb’s detonation has already reduced projected real GDP growth in 2013 from 3% to 2.5%, and has raised likely end-2013 unemployment from 7.5% to 7.7%. Each day from January 1 to June 30 that the damage continues will have a roughly linear impact on economic performance in 2013, reducing the likely full-year real GDP growth rate by 0.0084% – and only if a deal is ultimately reached that would have caused no economic harm in 2013 had it been reached on November 10, 2012. If no deal is reached by June 30, America’s likely 2013 real GDP growth rate will be -0.5%, with the likely unemployment rate returning to 8.9%.

Spending cuts and tax increases that in the long run restore fiscal sanity and balance are good. Having them all hit a weak, still-depressed economy simultaneously is not good. Thus, US officials face four tasks.

First, Republicans and Democrats must negotiate a bipartisan agreement to stretch out the spending cuts and tax increases that take effect on January 1, 2013. That way, they will affect the economy gradually over five years, rather than all at once.

Second, the Federal Reserve should expand its quantitative easing and forward guidance programs. Consumers will be spending less in 2013, owing to higher taxes, as will government, which means that someone has to be spending more. Housing construction and exports are the obvious candidates, and both can be boosted somewhat by more aggressive balance-sheet operations by the Fed, together with promises of continued low nominal interest rates and higher inflation in the medium term.

Third, the large government-sponsored mortgage enterprises, Fannie Mae and Freddie Mac, should be used as macroeconomic-policy tools to restore housing construction to its long-term trend level. This should have been done five years ago, but better late than never.

Finally, and also five years too late, the US Treasury secretary should announce that while the strong-dollar doctrine was appropriate (and in America’s interest) during the dot-com boom, the country needs a weak dollar in the aftermath of the austerity bomb’s detonation.

Reaching the wrong agreement to defuse the austerity bomb, or cushion the economy from its impact, would merely recreate America’s long-run structural budget deficit – a very bad outcome. Failure to take all four steps outlined above all but guarantees renewed recession in America, even if a good agreement is reached on stretching out the tax hikes and spending cuts. And if no agreement is reached on that, undertaking the last three steps would at least reduce somewhat the subsequent damage.

J. Bradford DeLong, a former deputy assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.

Copyright: Project Syndicate, 2012.

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