If you’ve been following politics at all since the election, you’ve almost certainly heard about the need for structured deficit reduction legislation to avoid the upcoming “fiscal cliff”. The cliff is a combination of expiring tax cuts, such as the Bush tax cuts and the payroll tax cuts, and discretionary spending cuts between the military and non-military budgets. Essentially, on January 1, taxes will go up a lot and government spending will go down a lot, unless Congress and President Barack Obama do something about it. However, any solution is almost guaranteed to be a combination of tax hikes and spending cuts anyway. Is thisright? I don’t think so.
Both Republicans and Democrats cite deficit reduction as necessary in order get government spending under control again. And it’s true that in the long term, we’re running up unsustainable deficits. However, there are two reasons why this is the worst time to go about reducing our deficit.
First and foremost, the US is still recovering from the Great Recession that began almost five years ago. Economic improvement has been steady but slow in the past few years, a trend to be expected of systemic banking crises according to Harvard economists Carmen Reinhart and Kenneth Rogoff . Basic macroeconomics says that when the economy is underperforming long term potential output, the solution is a combination of tax cuts and increases in government spending. This is what the stimulus bill sought to achieve, and it prevented the US from falling into another Great Depression. While our economy is undoubtedly in better shape than it was four years ago, we are by no means back to normal economic conditions. The Congressional Budget Organization projects that if Congress does not adapt the tax hikes and spending cuts set to take place, real GDP will decline by 0.5 percent and unemployment will rise from 7.9 to 9.1 percent. Structured deficit reform would probably do less damage, but the last thing we need right now is a loss in economic productivity.
The second reason why this is a poor time for deficit reduction is that the United States can borrow money extremely cheaply right now. Real long term interest rates are currently negative; that is, investors are willing to buy government securities knowing that they will lose purchasing power in the long term. Given that our government can essentially get money for free right now, there is no need to worry about the potential for default in the short term.
Furthermore, it is a common misconception that America runs up deficits by borrowing heavily from China. For every dollar invested in America, Americans invest 89 cents abroad. Foreign investment is a key component of global capitalism and is a driver of growth in countries across the world. In light of this, it makes no sense for the Chinese to suddenly call in their loans, as it would hurt both the American and Chinese economies.
Paul Krugman has written extensively on why this is an austerity crisis and not a deficit crisis here, here, and on his blog. I strongly agree with him on the issue of the deficit, as he is the only public figure who appears to truly recognize that we’re still in a recession. When the economy is underperforming long-term output, the solution is tax cuts and stimulus spending. The current plans proposed by Democrats and Republicans following the election, which consist of some combination of capping deductions on the wealthy, expiration of the payroll tax cut, ending the Bush tax cuts for the top bracket, and cutting discretionary spending, will do exactly the opposite, and potentially push us back into recession. Given that unemployment just fell below 8 percent and annual growth is under 2 percent, such a plan would be devastating. Worst of all is that this is not a crisis caused by market conditions that are out of our control; this is an entirely politically induced crisis who’s origins lie in our representatives in Washington. There is a significant chance that these politicians will needlessly destroy the American economy and the global economy in order to solve a non-existent problem.