Economics is not an experimental science. We can’t say to
Congress, “Honorable ladies and gentlemen, please drastically raise taxes and
cut spending all at once so we can measure the effects on the economy of changes
in the federal government’s budget.”
This is not what elected officials do — except that’s just
what is scheduled to happen come Jan. 1.
What a great experiment! Think how much we’ll learn.
Unfortunately, we’d all have to live inside this experiment. We would be the
mice in the maze.
It’s the famous fiscal cliff, of course. Come Jan. 1, the
Bush-era tax cuts expire, so everyone’s tax rates will increase.
The two-year cut in the Social Security payroll tax will
expire, raising taxes some more. The Alternative Minimum Tax won’t be adjusted
for inflation, so millions of people will see their taxes rise still more.
Automatic spending cuts will kick in, reducing both defense
and entitlement spending. Extended unemployment insurance will expire, so two
million people will lose benefits. And Medicare payment rates to doctors will be
You can get the amazing details from the Congressional
Budget Office in its annual budget and economic projection at
Add it up: These changes will yank about $500 billion out of
the economy. Higher taxes and lower entitlement payments will cut spending by
households and businesses.
Government will spend less, laying off employees and
canceling contracts with businesses. With spending down, businesses will have
less reason to produce goods and services, so they’ll cut production and reduce
The spending loss amounts to about 3 percent of the economy.
Since output has been growing less than 3 percent per year, the loss of that
spending will turn growth negative. That’s a recession.
The CBO projects a half-point decline in gross domestic
product by the end of 2013, with the unemployment rate climbing back above 9
But wait: With higher taxes and lower spending, the federal
budget deficit will decrease, and we’ll add less to the national debt. That’s a
good thing, right?
Yes, it is. The CBO projects that the higher tax rates and
lower spending will begin to reduce the national debt as a share of GDP.
By 2020, the debt will be down to 61 percent of GDP and
falling. Now, it’s 73 percent and rising.
When taxes are less than spending, the federal government
borrows the difference. Eventually, with too much borrowing, lenders will only
lend at higher interest rates.
Higher rates reduce borrowing by businesses. Investment
projects that would have added new equipment and better technology don’t get
done. Economic growth slows down.
The Federal Reserve may try to hold interest rates down by
increasing the money supply, but that leads to inflation. It’s a nasty choice:
recession and unemployment now or high interest rates, inflation and slower
There may be a way to avoid this nastiness. Deficits are not
causing problems now. We’ve been running huge deficits since 2008, yet lenders
still are falling all over themselves to lend to the federal government.
Interest rates are at record lows. Inflation is low, too,
despite trillions in new money created by the Fed. The problems we expect to see
from all that borrowing are nowhere to be found. That’s because an economy
trying to emerge from recession is different from one that’s fully recovered.
We’ve got unused capacity — workers without jobs, buildings
without tenants, factories closed or producing less than they could. That keeps
wages, rents and prices from rising, so we don’t get inflation.
Banks have money to lend, but don’t see enough low-risk
borrowers. Money not lent is money unspent, so it doesn’t add to economic
Federal government borrowing and spending in an economy like
this gives businesses a reason to produce and hire. It doesn’t crowd out private
Deficits now are OK. They help our economy. Congress needs
to agree to keep taxes down and maintain spending in 2013.
Once the economy has recovered, we’ll need to bring down
those deficits to prevent high interest rates and inflation. Congress needs to
agree on a plan to get that done.
Forget the experiment. We aren’t mice in a maze. We aren’t
lemmings on a cliff, either.