from Greenberg Center for Geoeconomic Studies and Renewing America: Debt and Deficits

Gridlock on U.S. Economic Policy

GOP election gains make it less likely Congress will enact needed deficit cuts and more fiscal stimulus, and the Fed’s quantitative easing plan could create new bubbles, says CFR Distinguished Visiting Fellow Peter Orszag.

November 05, 2010

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Gridlock resulting from midterm Republican gains in the U.S. House of Representatives and Senate is likely to make it difficult to enact policies to revive the flagging economy. Peter Orszag, former director of the White House’s Office of Management and Budget, says sluggish growth and high unemployment will persist for at least another year, though voter sentiment could improve ahead of the 2012 presidential election with even small economic gains. The election results reduced chances Congress will agree on a credible budget deficit reduction plan, he says, which he feels is a needed complement to additional fiscal stimulus. Orszag is skeptical about the Federal Reserve’s plans for a second round of quantitative easing, which he thinks could "create distortions in bond pricing that will lead to future bubbles." The most effective stimulus would be additional fiscal relief for state and local governments facing massive deficits, he argues, since their tax hikes and spending cuts work against the goal of boosting aggregate demand.

What do you expect to come of pending proposals to extend the Bush-era tax cuts, given the shift toward Republicans in Congress?

There will be a significant extension, whether it’s all of the tax cuts or just those earning less than $250,000 per year. Some are worried that the tax cuts will expire--even if it’s not dealt with during the lame-duck--but I think it will be dealt with very quickly when Congress comes back next year.

The notion that the president has all dials at his command that can just reduce the unemployment rate significantly if he just focused on the question is unfortunately not particularly realistic.

So the question is about the tax cuts for those earning more than $250,000. And question two is: Is the extension permanent or temporary? I don’t have a great bet right now on exactly where the lines are being drawn. What I think should happen is we should not make the tax cuts permanent, because we can’t afford to do so. Therefore any extension of any of the tax cuts should be for, say, two years. The best outcome would be to extend only the middle-class tax cuts for two years and then have them expire. But if the price of avoiding making any of the tax cuts permanent is to extend all the tax cuts for a temporary period of time, that’s better than making any of them permanent.

What about plans to reduce the deficit and long-term debt?

In terms of the deficit reduction, that would be required in 2015 or 2016--so not decades out, but three or four years out--the bulk of that is going to have to be on the revenue side [taxes] because the gap we face is so large, about 2 percent of GDP. The amount that you can get on the spending side, even with some of the proposals being discussed by some of the incoming Republican leadership, suggest a large piece that will have to be filled by revenue. And ironically, having the house flip to a Republican leadership probably makes any revenue piece even less likely than it was already, because Republicans are adamantly opposed to any significant revenue [tax] increase, despite all the rhetoric of fiscal discipline. There’s a tension between the rhetoric of deficit reduction and the fact that--even under the proposals that are being discussed--there’s not that much traction on making spending cuts, and certainly not enough to fix the whole problem. This election arguably reduces the chances of a credible medium-term fiscal package being enacted.

Where do you see the economy heading before 2012, in the run-up to the presidential election?

Several factors suggest sluggish growth, so that it will continue to be an economic environment no one is particularly pleased with, even though modest growth has returned--and that’s better than having the economy declining. The history of recovery from downturns caused by financial market problems [and] banking sector problems suggests that they take a while to work their way through. In addition to that, a bunch of temporary factors are now headwinds against the economy, including the Recovery Act and the stimulus bill--which did add to economic growth--coming offline. State and local deficits need to be closed; the inventory cycle, which was adding to growth earlier this year, is slowing down; and we’re going to hit neutral by the end of this year, early next year.

There are good reasons to be skeptical, both about how much quantitative easing will help and about whether it will create distortions in bond pricing that will lead to future bubbles.

So there were forces actually adding significantly to growth the first half of this year that will reverse by the first half of next year. All of that suggests that, at least for the next twelve and maybe for the next twenty-four months, the best expectation is very sluggish growth that won’t dramatically reduce the unemployment rate. Maybe we’ll get lucky and the world will turn out much better than those expectations, but that’s the most likely outcome at this point.

Can Obama turn around voter sentiment on the economy in that time period?

I don’t want to get into political science, but voters are said to depend not only on the absolute level of economic activity but also recent changes, so when things are getting better, even if they’re not great yet, that leads to a sense of optimism and is beneficial.

A recent Wall Street Journal op-ed argued that Obama should learn from the economic and political turnaround under former president Ronald Reagan, when economic growth shot up from -1.9 percent in ’82 to 7.4 percent in ’84. Is that kind of economic rebound even possible now?

That’s not really because of anything President Reagan did, but instead because the economy had gone through a very steep downturn caused mostly by the Federal Reserve, on purpose, and then had a rapid recovery following that. The difficulty is when people say, "The president should focus on the economy," perhaps that’s right, but the question is: What exactly do you want him to do that will have a significant effect on the unemployment rate? The right policy combination at this point is more stimulus now, more deficit reduction enacted now that takes effect in two or three years, and dialing down the temperature on some of the tension that has arisen between business and administration. The first two require legislative activity, and they’re very unlikely to happen. On the final one, perhaps the administration can make a bit of progress, but the notion that the president has all dials at his command that can just reduce the unemployment rate significantly if he just focused on the question is unfortunately not particularly realistic.

CFR’s Benn Steil recently wrote that attempting to boost aggregate demand through more stimulus ignores sector-specific problems in the economy and leads to asset bubbles. What do you think of that, given your support for more stimulus?

The fundamental problem right now is inadequate aggregate demand, and boosting that would be beneficial. Now, that having been said, one does want to worry about creating new bubbles. I worry less about that happening with fiscal stimulus than with the next round of quantitative easing. In fact, there are good reasons to be skeptical, both about how much quantitative easing will help and about whether it will create distortions in bond pricing that will lead to future bubbles. So, I am skittish about the next round of quantitative easing, and much less [skittish] about a next round of fiscal stimulus, if it were coupled with a credible deficit reduction package. I don’t think we should have fiscal stimulus by itself at this point, but that combination would be exactly what we need.

What would the fiscal stimulus look like?

There’s a classic dichotomy between what many members of Congress want and between, for example, what the Congressional Budget Office says would have high bang for the buck. Among the most effective things that one could do at this point would be additional fiscal relief for the state and local governments which are facing massive deficits. Their actions [state and local governments] are counterproductive from an aggregate demand perspective, because they’re raising taxes and cutting spending. And having more federal support to mitigate that might be the most effective thing that we can do. It’s unlikely to happen given the shift in Congress, or even before the shift in Congress. Some of the other ideas under discussion include a payroll tax holiday, additional infrastructure spending, and so. There are many ways that it can be done, but again, it should be done if it’s in conjunction with having more a credible path of fiscal sustainability over the next five to ten years.

What about Europe’s drive toward fiscal austerity? Is that helping or hurting the cause of boosting global growth?

There are myths on both the left and the right. The thought that in the current environment, when interest rates are already so low, that immediate austerity--as opposed to austerity enacted now to take effect within two to three years--is beneficial, strikes me as unlikely. You have a drag to aggregate demand from the direct impact [of those policies], and then you need to overcome that through two channels. [First is] an interest rate channel, which is unlikely to be that powerful given how low rates are anyway and how unresponsive investments seem to be to interest rates--which is another reason why quantitative easing is not likely to be that beneficial. And then second [is] a confidence effect, having more confidence about the [fiscal] path we’re on. You can get that confidence effect by enacting credible [budgetary] policies now to take effect in two or three years, and you don’t have the immediate drag of actually having them take effect now. I would be quite concerned if we did the same thing here, because it would be repeating the mistake from 1937.

Is it a mistake for surplus countries, such as Germany?

No. It’s a little less damaging, in the extreme, if you’re a small open economy and therefore less dependent on domestic demand than in a larger open economy like the United States. That having been said, it’s still not particularly helpful. It would be better to have the austerity enacted now and delayed a couple of years just to avoid the risk of another substantial implosion in demand.