The chart above is from a Goldman Sachs analysis, and it shows the effect of fiscal policy on growth from 2009 to the present, as well as projections for growth in a variety of scenarios surrounding the fiscal cliff, the combination of expiring tax cuts and imminent spending cuts all set for the end of the year.
I think there are a number of things notable about this. First, you have the fact, contrary to popular belief, that America never really experienced a fiscal stimulus. The stimulus had an impact on growth in the first two quarters it was operative, in Q2 and Q3 of 2009. After that, state budget cuts basically canceled out whatever the stimulus provided. Every quarter since Q4 of 2009 has shown a negative contribution to growth from federal, state and local fiscal policy. And since Q3 of 2010 – when Democrats still controlled Congress – federal fiscal policy has either been flat or negative for growth. If we pull forward to this year, we see that state and local spending has stopped hindering growth. Only federal policies drag on growth at this point, with the stimulus expired and cutbacks in fiscal accommodation from the government.
Now, I know if I were the President, I would not be bragging about this. But it goes a long way to explaining the slow or non-existent recovery we have had since the Great Recession. Keynesian theory suggests that you fight recessions with fiscal spending instead of austerity. This chart shows that we effectively did not do that. And the results in terms of economic performance fit with that.
Then you have the fiscal cliff, and Goldman offers three distinct scenarios for the lame duck session. If everything gets extended – the Bush tax cuts and associated tax measures – and the trigger cuts get subsumed, then fiscal policy would still cut into growth, but by less than 1% of GDP. If everything expires under current law, then the hit to growth is very sharp. For the first three quarters, fiscal policy would cause a 3-4% slowdown in growth. Since the economy isn’t expanding currently at a 3-4% growth rate, that would mean a brief return to recession. Finally, Goldman includes a “current assumption,” which has the payroll tax cut expiring, jobless benefits extended but pushing down to a maximum of 59 weeks, the Bush tax cuts extended for a year and the trigger cuts avoided. That would create a slightly larger fiscal hit than if everything got extended, but still on the order of a 1% hit to growth.
Looking beyond just this fiscal hit, there is a logic to letting all the Bush tax cuts expire and then coming back with “Obama tax cuts to avoid a recession” in the new year. This gambit pretty much worked with the payroll tax cut at the beginning of this year, but it depends on who’s sitting in Congress and the White House come 2013.
Anyway, as the Center for a Responsible Federal Budget notes, the real danger to the economy comes from the spending cuts in the trigger, not the tax cuts. The spending cuts would have a more powerful effect on growth.
All of this argues for an insurance policy against future growth problems, either from Europe or this fiscal drag, in the form of additional investment right now, both from the monetary and fiscal channels. That’s a pipe dream in Congress, but the Federal Reserve should figure this one out by now. The headwinds from Europe are real, and the fiscal cliff, even if it produces some kind of “grand bargain,” will end up dragging down growth. It makes perfect sense to provide additional investments to secure higher growth and hedge against the economic risks out there. That’s why it won’t happen.