- Failure of the “Super Committee” to reach agreement on cutting deficits by at least $1.2 trillion through 2021 now appears all but certain.
- Our recent forecasts have assumed agreement on $1.5 trillion of deficit reduction, with two-fifths in revenue increases and three-fifths in spending cuts, and with the fiscal contraction back-loaded.
- The Budget Control Act (BCA) requires automatic sequestration to save $1.2 trillion spread equally over 2013-2021. This would imply significantly more drag in 2013 than assumed in our forecast (see chart).
- However, there would remain nearly a year to come to some agreement that could alter the path of fiscal contraction and still meet longer-term deficit reduction goals. Thus, we will not alter our fiscal assumptions based on the failure of the Super Committee to satisfy the requirements of the BCA. We already had assumed no extension of the payroll tax holiday or emergency extended unemployment benefits.
- The biggest risk to the economy in the near term is posed by the reaction of financial markets. Stock prices are falling sharply as we pen this note. Increased macroeconomic uncertainty from failure of the Super Committee to meet its mandate may yet further roil credit markets, including a possible further downgrade of U.S. debt, and contribute to a weaker near-term outlook.
- We continue to believe long-term deficit reduction is absolutely critical for the long-term health of the U.S. economy. However, if it is too front-loaded, coming at a time when the Federal Reserve is unable to effectively cushion the economy from the effects of fiscal contraction, it would do unnecessary harm and slow the decline in what is already a painfully slow fall in the unemployment rate.
The press is reporting that the bi-partisan Congressional “Super Committee” charged with finding a minimum of $1.2 trillion in debt reduction over the next decade today will announce its failure to report a set of recommendations. Apparently neither side was willing to soften their positions on the mix of spending cuts and revenue increases sufficiently to forge an acceptable compromise. On paper, the Committee’s failure will, effective 2013, result in automatic spending cuts (or a “sequester”) totaling $1.2 trillion through 2021. These will be split evenly between “security” and “non-security” outlays and, by our reading of the BCA, be spread evenly over the 9 years.
Our recent forecasts have assumed that the Super Committee succeeds in finding $1.5 trillion in debt reduction—actually more than required by the BCA—but the savings we’ve assumed are back-loaded and divided roughly into two-fifths tax increases, which have a relatively small impact on aggregate demand, and three-fifths spending cuts. Hence, relative to our current forecast a “sequester” implies twice as much fiscal drag in 2013 as shown in our current forecast. The alternative calculations for static fiscal drag are shown in the chart on the next page.
The Committee’s failure has the potential to alter our forecast in two ways. First, the particular paths for spending and tax rates assumed for 2013 and beyond do have a direct bearing on our projections for aggregate demand after next year. If we were certain the sequester will now occur, we would mark down our forecast for 2013 but mark up our forecasts for the subsequent years. However, it is too early to know what really will happen: there is still over a year to go! Some Republicans already are preparing to undo the “automatic” cuts in defense spending. Considering all the possibilities, the result of the Committee’s failure could be more, not less, direct stimulus in 2013 than shown in our current forecast. So, until this situation becomes clearer, we will not change our fiscal assumptions for 2013.
Second, the immediate reaction of financial markets to the failure might lead us to change our forecast even before 2013. As of this writing, stock prices are falling sharply, and at least some of that decline is likely due to the market’s disappointment over the failure of the Super Committee and, by extension, Congress to “govern.” If the slump in stock prices sticks, and to the extent investor, business and consumer confidence slump with the failure in governance, the economy could weaken in the near term. We’ll have to wait to gauge market reactions to the Committee’s failure. Surely, however, some significant probability of the Committee’s failure has been “priced in” all along.
It now seems likely that major progress on the deficit reduction will not occur until after the upcoming presidential election, with both parties viewing the election as a referendum on the mix of taxes and spending. In the meantime, if the automatic spending cuts are undone before 2013, Congress will have revealed the folly of a Balanced Budget Amendment (BBA), which would require cuts far larger than those debated by the Committee and so likely would be somehow circumvented the first time that adhering to the BBA required a painful fiscal contraction.
This is from a commentary that was published on November 21, 2011.
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