It’s hard to be happy about the prospect of the sequester—the huge, automatics cuts to domestic spending set to take place if lawmakers can't reach a long-term budget deal—going into effect at the end of the week. Not only will it will mean substantial cuts to important programs; it will be a further drag on an already weak economy, shaving 0.6 percentage points off our growth rate. The end of the payroll tax cut, which expired on January 1, has already pushed it down to around 2.0, but the sequester cuts will depress it below the rate needed to keep pace with those entering the labor market. As a result, we are likely to see a modest increase in unemployment over the course of the year if the cuts are left in place.
Of course, it could be worse. Half of the cuts are on the military side. This will help to bring our bloated military sector closer to its pre-September 11 share of the economy, and going forward, the principle that domestic cuts be matched by cuts in defense spending is certainly better than the idea of attacking domestic spending alone. In addition, the most important programs in the budget—Social Security, Medicare, and Medicaid—have been largely spared the ax—an important victory in the 2011 negotiations.
Thus far in the negotiations, the Obama administration has indicated a willingness to play hardball. Rather than shielding areas where the effect of cuts would be most notable, it is planning to reduce staffing in air traffic control and airport security. This will lead almost immediately to canceled flights and long security lines at airports. That is likely to provoke many angry phone calls to members of Congress.
The next step at that point is unclear. President Obama has explicitly offered cuts in Social Security and Medicare if the Republicans will go along with higher taxes. For those who oppose cuts to these programs, the generous view of this maneuver is that he knows that the Republicans won’t budge on taxes; by offering a compromise, he is simply making them look unreasonable. The less generous view is that he is actually willing to make cuts in these programs, sharing the view of Washington Post-centrist types that seniors are living too high on the hog.
While the odds are against a “grand bargain” that couples tax increases with cuts to Medicare, Medicaid, and Social Security, it remains a possibility. However, it’s more likely that President Obama and Congress will agree to some scaled-down version of the sequester, with fewer cuts and maybe some small revenue raisers that Republicans will decide they can accept. This will have the deficit hawks yelling and screaming, but that would be the best plausible outcome from the standpoint of the economy.
As pundits and the Washington establishment hone in on the sequester this week, what remains unfortunate in this picture is that there is still little willingness to talk realistically about the relationship between the economy and the budget deficit. Both parties have played into the myth that out-of-control budget deficits are a chief economic problem. Democrats have pushed this line to call attention to the Bush tax cuts and the fact that he did not pay for the wars in Iraq and Afghanistan. Republicans push the line to feed the notion that government is overspending.
The simple truth is that budget deficits were quite modest prior to the economic collapse in 2008. The budget deficit in 2007 was just over 1.0 percent of GDP and the debt-to-GDP ratio was falling. The debt-to-GDP ratio was projected to continue falling even if the Bush tax cuts did not expire as expected at the end of 2010.
The reason that the deficit suddenly exploded in 2008 and 2009 was that the economy collapsed. This led to a plunge in tax revenue and an increase in payments for programs like unemployment insurance. We deliberately added more to the deficit with the stimulus. This was done in a context where demand in the private sector was not sufficient to support the economy.
Rather than being a bad thing, the deficit is providing a needed boost to the economy. There is no plausible story whereby private-sector demand will fill the gap created by a smaller deficit. Whether they know it or not, those pushing for smaller deficits are promoting less growth and more unemployment. It would be the best possible outcome of the sequester debate if this simple point could be made in polite circles in Washington again. Until we have a reality based discussion of the budget and the economy, the only question will be how much we lose from the latest deal.