Between a fiscal rock and a hard place

The Congressional Budget Office paints a tough choice: either shrink the deficit or tackle unemployment. Can Congress steer a middle path?

Congressional Budget Office Director Douglas Elmendorf at a Monitor Breakfast on April 8. Director Elmendorf argues that we must choose between fiscal responsibility with ongoing unemployment or an exploded deficit with fewer jobless.

Michael Bonfigli/Staff

August 24, 2010

The Congressional Budget Office’s annual mid-session update provides some striking evidence of just how challenging today’s fiscal environment is. Because deficits were so high going into the economic slump, and because the financial crash was so steep, Washington must now navigate between two unacceptable outcomes: tight fiscal policy and slower growth now, or bigger deficits and slower growth later.

CBO’s latest estimates, summarized nicely in this blog by director Doug Elmendorf, paint the choices in stark terms. On one hand, if we let all the Bush tax cuts expire, allow stimulus to come to an end, and permit domestic spending to grow only fast enough to keep up with inflation, we can bring the federal deficit down to 4.2 percent of Gross Domestic Product in 2012, less than half of this year’s 9.1 percent. Once the economy recovers, deficits would settle in at manageable levels of between 2.5 percent and 3 percent from 2014 to 2020. This scenario, which effectively extends current law, sounds pretty good if the deficit is your biggest worry.

But CBO figures that if we follow that path, the economy would grow by an anemic 2 percent over the next year, and it would be 2014 before the unemployment rate falls to 5 percent from today 9.7 percent. Not so good if your chief concern is fixing the short-run economy.

At the other extreme, we could extend the Bush tax cuts, continue to exempt millions of Americans from the Alternative Minimum Tax, and maintain government spending at relatively high levels. These policies would add between 0.6 percent and 1.7 percent to growth, relative to the tighter fiscal path. As a result, unemployment 15 months from now would be as much as 0.8 percent lower.

The downside, however, is the deficit in 2020 would reach 8 percent of GDP, nearly twice what it would be if the tax cuts disappear and we limit spending. And over the long run, these higher deficits would take a severe toll on the economy.

CBO’s forecast is just that, and both the economy and the deficit are likely to grow at a somewhat different rate than it projects. But the broad story it tells is pretty accurate. So what to do?

The solution, duh, is to chart a middle course. For instance, Washington could continue a relatively generous fiscal policy for the next year or two--until financial markets, housing, business investment, and employment get back on their feet. But at the same time, it could start phasing down government spending and increasing tax revenues, with an eye towards reaching something resembling fiscal balance in the second half of this decade. It can begin doing that now.

It is easy to imagine what this middle ground looks like: Congress could extend some of the Bush tax cuts for only a year or two and use that time to begin the work of restructuring the tax code, key to creating a revenue system that can support the government we seem to want. At the same time, it could adopt steps to gradually control long-term spending. The harder part is imaging the political will that will get us there.

Add/view comments on this post.

------------------------------

The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here. To add or view a comment on a guest blog, please go to the blogger's own site by clicking on the link above.