We've heard much about the "fiscal cliff" that might appear at the beginning of 2013 if lawmakers fail to act to curb the tax hikes and spending cuts that are slated by current law to kick in at that time. The nonpartisan Congressional Budget Office noted recently that growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5% -- while the economy is projected to contract at an annual rate of 1.3 % in the first half of the year and expand at an annual rate of 2.3% in the second half. In other words, under current law, we would have a recession in the first half of 2013. With that in mind, it seems that everyone is worried about the fiscal cliff. After all, that starts in just six months. It's not that simple, though, to just go back to where we were before these budget reduction efforts were enacted. There is a very valid reason for cutting the deficit, after all. And in that vein, the CBO did a separate study pertaining to the longer-run effects if we enact the laws that are most likely to help us avoid the fiscal cliff. And those results aren't pretty, either. While lawmakers may want to cut spending and increase revenue a bit less abruptly than in the "cliff" scenario, the current trajectory of debt growth is well beyond unsustainable. First, with the fiscal cliff, our federal debt held by the public would gradually decline over the next 25 years, from an estimated 73% of GDP this year to 61% by 2022 and 53% by 2037. That's a good thing. Here's what would happen if the fiscal cliff is avoided by lawmakers changing current law in the manner the CBO believes Congress might do: "Federal debt would grow rapidly from its already high level, exceeding 90% of GDP in 2022. After that, the growing imbalance between revenues and spending, combined with spiraling interest payments, would swiftly push debt to higher and higher levels. Debt as a share of GDP would exceed its historical peak of 109% by 2026, and it would approach 200% in 2037." Ouch!
So you think that the 1.3% contraction in GDP in the first half of 2013 is bad with the fiscal cliff? The higher debt levels that we would incur if we continue to the path we have been following would result in a reduction in GDP by 4% in 2027 and by around 13% in 2037. This is compared with what GDP would be if the federal debt held by the public were held constant at its current levels. The Richmond Fed did some research into what happens in these high-debt scenarios, beyond what the CBO already reported. Obviously, at some point, interest rates may spike. We are currently benefiting from a flight-to-quality trade from the situation in Europe that may be helping keep our interest rates lower than what they would be otherwise, and that may prove temporary. Another situation is that the public may believe that the Fed will allow inflation to increase, in order to reduce the real debt burden. This would involve paying back interest and principal that would be worth somewhat less in future, inflation-devalued dollars. Importantly, even if the Fed is committed to maintaining low inflation, a surge in the public's inflation expectations may itself cause inflation to spike. Adding rising inflation to already-skittish investors' unwillingness to buy our debt could then cause interest rates to soar even more, thereby making a bad problem even worse. The Fed might then be powerless to stop inflation, given the strong role of inflation expectations in begetting inflation, and the Fed's unwillingness to raise interest rates to punitive levels in an economy that could be weakened, and given a government that depends on borrowing. So, when you hope that lawmakers work to avoid the fiscal cliff, consider what happens if current spending and revenue policies are unchanged. Our nation's leaders face an immense challenge of finding that fine balance of the right timing and the right means of raising revenue and/or cutting spending. Are our policymakers up to the task?