Cut Deficits Without Killing the Recovery?

At the core of Washington's exasperating budget debate lies a confusing disconnect. On the one hand, we're urged to reduce huge and endless budget deficits, which are said to threaten a future financial crisis. The Congressional Budget Office's latest projections - released this week - envision $7 trillion worth of deficits over the next decade, a figure that could, under plausible circumstances, grow to exceed $9 trillion. On the other hand, we're cautioned against doing too much deficit reduction too quickly because steep spending cuts or tax increases might undermine the weak economic recovery. In effect, we're instructed both to reduce the deficits and not to reduce them.

The contradiction is one reason the budget debate perplexes and paralyzes Americans. We are getting a lot of conflicting advice. Can the different goals be reconciled? The answer is "yes" - at least on paper, though perhaps not in the real world. At a recent briefing, CBO Director Douglas Elmendorf did as good a job as anyone in explaining how.

The CBO's analysis epitomizes the "on the one hand, on the other" dilemma. The CBO has consistently warned that the large federal debt poses long-term dangers. Its latest report echoes those fears. By 2023, it projects that the publicly held federal debt will reach almost $20 trillion, nearly double 2012's $11.3 trillion. Debt as a share of the economy would rise from 2012's 73 percent of gross domestic product (GDP) to 77 percent. As recently as 2007, the debt/GDP ratio was 36 percent. The debt buildup, the CBO says, poses three dangers. The first is the financial crisis: Lenders might flee from buying Treasury debt. Second, large government borrowing could crowd out private investment and jeopardize future gains in living standards. Finally, the high debt might limit government's ability to borrow heavily if a new need arises - from war, an economic crisis or natural disaster.

So, the message is clear: However painful, get a handle on the debt.

But the CBO also warns that drastic debt reduction might backfire by harming the recovery. Even the relatively mild measures enacted for 2013 will retard growth, says the CBO. Recall what these are: the end of the 2 percentage-point cut in Social Security payroll taxes; the cuts in defense and non-defense discretionary spending mandated by the Budget Control Act of 2011; and tax increases imposed on high-income households (mainly singles with incomes above $400,000 and married couples with incomes exceeding $450,000). In 2013, the CBO projects that the economy will grow only 1.4 percent. Without the deficit-reducing measures, growth would be about twice that, it reckons. The difference is worth about 2 million jobs in 2013, according to Elmendorf.

The exit from this dilemma, Elmendorf suggested, is to time deficit reduction with a strengthening private-sector recovery. As private spending improves, cuts in government spending or tax increases would threaten the economy less. Elmendorf argued that the transition from government-generated to private demand is now occurring. Americans have paid down loans; they have more leeway to increase everyday spending. Rising home values and stock prices have boosted confidence. Employment is increasing. State and local government spending is stabilizing. "We see momentum building," says Elmendorf. The CBO has economic growth picking up to 2.6 percent in 2014 and then averaging about 4 percent through 2017. Unemployment falls from 2012's 8.1 percent to 5.6 percent by 2017 (annual averages).

So the conflicts can be reconciled, with one big "if." The private sector's recovery has to be vigorous enough so that deficit reduction's dampening effects can be absorbed without causing a new recession. After nearly four years of lackluster growth - even with massive doses of "stimulus" from the budget and the Federal Reserve - this remains a crucial unknown.