Three Fiscal Flashpoints that Can Cause a Recession

Three Fiscal Flashpoints that Can Cause a Recession

iStockphoto/The Fiscal Times

Policymakers, business, markets, and households alike are more aware than ever of the dangers posed by the federal government’s fiscal affairs.

Indeed, there are three flashpoints that pose distinct dangers and require different solutions.  Unfortunately, the vast majority of discussion and commentary intermix the three in problematic ways.

The first danger is the fiscal cliff – a combination of $440 billion in automatic tax increases (sunset of the payroll tax holiday, sunset of the 2001 and 2003 tax laws, alternative minimum tax, and new taxes from the health care reform) and $200 billion in spending cuts (the sequester from the Budget Control Act of 2011, cuts to doctors treating Medicare patients, and the end of augmented unemployment benefits).  Going over the fiscal cliff would constitute a shock to the economy equal to 4 percent of GDP – a guaranteed recession. 

Addressing this danger requires being good stewards of the economy so as to get to the spring of 2013 without a fiscal shock that leads to recession.  At present, it appears to be a fait accompli that the payroll tax holiday will sunset, placing a premium on extending the rest of current policy for one year – tax rates, unemployment insurance (UI) benefits, Medicare payments, spending cuts – to avoid disaster.  That’s good, because Congress’ strongest impulse and greatest skill is to kick tough issues down the road.  The only exception is that the blunt, dangerous, across-the-board cuts in 2013 discretionary spending should be replaced with longer-term reductions in mandatory outlays – the part of the budget the so-called “super committee” was supposed to control in the first place.

The second danger is the need to raise the federal debt limit, likely in February or March.  The limit is a symptom of another real problem – spending; and therefore, any increase needs to be accompanied by corresponding deficit reduction.  The events of the summer of 2011 bear stark witness to the political toxicity of this mix.  The right solution is a small increase in the debt ceiling, matched with deficit reduction, to buy time until August 2013.

The final danger is the fundamental unsustainability of the federal budget. After four consecutive years of trillion dollar deficits and the accumulation of $6 trillion in new debt, the future is even bleaker.  Left unchanged, the exploding debt burden will drag down the economy and assure a Greek-style financial crisis.  It is the single most important economic and national security threat. 

This simply cannot be kicked down the road.  If serious progress is not made by August 2013, markets will (correctly) conclude that the poisonous U.S. political climate precludes dealing with serious problems – even in the honeymoon period of a new Congress and Administration.  The ratings agencies will collectively downgrade the U.S., capital will be impaired across the financial system, credit will freeze and a second Great Recession will ensue.

It is folly to lump these efforts together.  Trying to deal, for example, with the longer-run scale and progressivity of the tax system – raising top rates – in the lame duck will prove too difficult because it must be accompanied by serious entitlement reforms.  The result will be gridlock and a nation hurtling over the fiscal cliff.

Tying the fiscal cliff to the debt ceiling increase is equally folly.  Tax hike and spending cuts that will necessarily be part of the discussion surrounding the debt ceiling increase are at odds with the need to avoid a fiscal shock. 

The right strategy is to make sure that the underlying political issues will not get in the way. This means averting the fiscal cliff and getting to 2013 unscathed, pushing the debt ceiling modestly with equal parts deficit reduction, and giving the new Congress and Administration a clear agenda to focus on the real problem: burgeoning debt driven by unchecked spending increases.  Fundamental tax and entitlement reform will sweep away any future fiscal cliffs and debt ceiling debates.  It is the top priority and the sooner they are dealt with, the better.

Douglas Holtz-Eakin is president of American Action Forum and former CBO director under George W. Bush.