Last week, Ben Bernanke delivered a speech in which he agreed that the government should reduce the deficit. However, he cautioned, "a sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery."
In economist speak, that's a warning to Vice President Joe Biden and the handful of congressional leaders he has assembled to tackle the deficit: Don't cut spending too fast or you'll kill the economy. Already, the federal government's limit on the amount it can borrow has been reached, and Treasury Secretary Tim Geithner has warned that the government is now taking "extraordinary measures" to meet its obligations. Yet Republicans refuse to raise the limit without big cuts to government spending.
Also last week, Sen. Jon Kyl, a Republican from Arizona and a member of the Biden negotiating team, reiterated his party's demand: Every dollar the debt ceiling is increased must be accompanied by at least a dollar in spending cuts. That would require a $2.5 trillion deficit-reduction package that would rely on spending cuts and not include tax increases, according to Kyl.
Kyl gave no timeframe over which that $2.5 trillion in savings would be spread. But Republicans have insisted on taking immediate steps to reduce the nation's current budget deficit, estimated at $1.6 trillion. The first batch of cuts could commence as early as this October, when the 2012 fiscal year begins.
Most economists warn, as Bernanke did, against an immediate drawdown in federal spending. With business investment, trade and consumer spending all still lagging, government remains the only actor with the power to maintain economic demand. "Curtailing the one major consumer that is continuing to consume -- it's just a terrible idea, especially when you have a major demand gap," says Michael Linden of the Center for American Progress.
We don't have to guess the outcome if Republicans succeed in cutting federal spending. Earlier this year, Republicans proposed a budget for the rest of the current fiscal year that included $100 billion in spending cuts. Many analysts from groups like the Economic Policy Institute, Moody's Rating Agency, and Goldman Sachs calculated the effect of those spending cuts on the economy, and they all foresaw major job losses and reductions in GDP growth. Economist Mark Zandi's analysis for Moody's predicted the economy would lose 700,000 jobs this year as a result. Given that there's nothing about the economic picture in the next fiscal year that is appreciably different from this one, there is little reason to believe cutting spending against would yield a different result. "Those are reasonable estimates for what you could point to," Linden said.
The budget framework that House Republicans are using for appropriations bills, which serves as an indication of what they want from a debt-limit deal, restricts discretionary spending by $103 billion more than 2010 levels, a cut of 21.5 percent, according to the Center for Budget and Policy Priorities. "It definitely violates the 'do no harm' principle in the short term," said CBPP's Chuck Marr, who estimates a loss of 1 percent of GDP this fiscal year under the Republican budget. Nonetheless, the Republican Study Committee, a conservative rump faction, wants an even larger spending reduction for FY 2012, some $380 billion in cuts. According to Larry Mishel of the Economic Policy Institute, cuts at that level would ensure a double-dip recession.
One only needs to look to Britain, which cut $180 billion from its budget last year, to preview the disastrous effects of such a cut. The economy shrank, and real household income dipped to its lowest level since the 1930s. "There's no way that budget cuts are not going to slow down the growth of the economy," said EPI's Mishel.
If anything, the economy is even more fragile than it was at the beginning of the year. Soaring gas prices, the European debt crisis, and strained supply chains after the Japanese earthquake have hurt countries around the globe. But also, a series of stimulus measures enacted in December's tax-cut deal are slated to run out at the end of this year. This includes extended unemployment benefits and the employee-side payroll tax cut, two programs that cost $177 billion through 2011. Letting them expire would contract fiscal policy by that amount, on top of the contraction from the budget cuts.
This paints a dire picture for 2012 -- a presidential election year. Given the current state of the economy, there's an urgent need not just to maintain the status quo, but to shore up the economy. "We should not just be talking about extending existing measures, we should be talking about new ones," says Linden.
In theory, policymakers could construct a deal with a fiscal stimulus in the next two years followed by significant reductions in spending in later years to hit a longer-term deficit-reduction target. In this scenario, Democrats would get stable economic growth in the near term, while Republicans would get the deficit stabilization they want. The People's Budget from the Congressional Progressive Caucus works this way, providing stimulus from infrastructure investment and other programs in the near term, and brings the budget into balance in later years by letting the Bush tax cuts for the wealthy expire, reducing military expenditures through ending the wars in Iraq and Afghanistan, and adding a financial speculation tax. Senate Democrats like Tom Harkin and Jay Rockefeller recently proposed increasing spending on infrastructure as well, as part of a job-creation-now, deficit-reduction-later approach. Such a bargain would be more likely to work, because nothing reduces the deficit like increased economic and job growth and the surging tax revenues that go with it.
"In a rational world, it should be possible to create a deal," says Linden. "Unfortunately, economic Luddite-ism has overtaken one of the major political parties. They are resistant even to stimulative measures that they would normally be for, like tax cuts."
Republicans theorize that a deficit deal would increase confidence in the business sector and financial markets, spurring economic growth all by itself. But there's ample reason to suspect this "expanding by contracting" theory. Sadly, the Obama Administration appears to have swallowed it. Last week, several White House officials, including Director of the National Economic Council Gene Sperling, stressed deficit reduction as the primary component of their economic-growth strategy, and repeatedly claimed that reducing the deficit would generate "confidence."
However, the numbers show that the economy suffers from stubbornly high unemployment and a gap in aggregate demand -- not a lack of confidence. The greatest indicator of confidence in the long-term fiscal picture is the interest rate for 10-year Treasury notes, and at historically low levels, they show the markets are unmoved by the budget deficit at this time. The Roosevelt Institute's Mike Konczal characterizes the confidence theory as "substituting the interests of the bondholders for the entire economy."
Crucially, there's no need to choose between job-creating stimulus and allegedly confidence-building deficit reduction; the plan to increase spending now and lower it over time combines them. That seemed to be the Obama administration's strategy before it shifted, with immediate, job-destroying budget cuts now apparently a central part of any deal, called a "bipartisan down payment" by Sperling.
"I think it's bogus," said Mishel, of EPI. "And it reflects what happened in the Clinton era, when you elevate a tactic to the level of principle. They feel politically forced into shifting to deficit reduction. And they now rationalize this as good for jobs. And I think they all know better."