A Mark Sadowski post
The subject of the United States “fiscal cliff” as a test of monetary policy offset at the zero lower bound in interest rates has recently come up yet again. Russ Roberts brought it up here.
Simon Wren-Lewis responds here.
To which Scott Sumner replies here.
For what it’s worth, here’s my two cents worth. I’ve said some the following before in more than one place, but this time I’ll try and be even more complete and explicit.
To begin with, the sequester was only a small part of the U.S. fiscal consolidation that took place in 2013. The “sequester” refers to the automatic spending cuts in particular categories of outlays that were initially set to begin on January 1, 2013, as a result of the Budget Control Act (BCA), and were postponed by two months by the American Taxpayer Relief Act of 2012 (ATRA) until March 1. ATRA also addressed the expiration of certain provisions of EGTRRA and JGTRRA (the “Bush Tax Cuts”), the 2-year old cut to payroll taxes (the “Payroll Tax Holiday”) and federal extended unemployment insurance. An increase in income tax rates applicable to high income tax payers, an increase in the payroll tax, and a continuation of federal extended unemployment insurance went into effect on January 1, 2013.
In short, the sequester only refers to the spending cuts that went into effect on March 1, 2013 and does not include the two major tax increases that went into effect on January 1, 2013. Based on the CBO’s November 2012 analysis of the “fiscal cliff”, and adjusting for the late start of the sequester, the tax increases that went into effect constituted approximately 70% of the budgetary effect of going over the “cliff”. This is why analyses such as these are far less than fully satisfactory.
Furthermore, none of the forecasts concerning the effects of fiscal consolidation, by either the CBO, or the major private forecasters, referred to annual 2013 RGDP growth. They all referred to quarterly RGDP growth in 2013 or to year on year RGDP growth in 2013Q4. This because this is the more reasonable measure when the question is what impact a budgetary change starting at or near the beginning of a given year will have on subsequent growth. The Q4/Q4 measure is approximately the average of the four quarterly growth rates following the budgetary change, whereas the Year/Year annual measure is essentially a weighted average of the previous and current year’s quarterly growth rates. In this particular instance 3/8ths of the weights in the Year/Year measure come from quarters that occurred before even a single act of the federal fiscal consolidation went into effect on January 1, 2013. For more on why the Q4/Q4 measure might be preferred to the Year/Year measure in this case, see this for example.
The CBO’s last full economic forecast of 2012 (which came out just weeks before QE3 was announced) called for 0.5% year on year decrease in RGDP in 2013Q4 assuming all of the projected fiscal tightening went into effect (Table 2-1).
The previously mentioned November 2012 CBO analysis of the effects of the fiscal cliff states that eliminating all of its components would result in year on year RGDP growth in 2013Q4 being 2.9 percentage points higher (Figure 1). This implies that the CBO was forecasting that year on year RGDP growth would be 2.4% in 2013Q4 without any of the components of the fiscal cliff.
A careful reading of the CBO’s estimates from November 2012 indicates that the fiscal consolidation (the 2% payroll tax increase, the high income tax increase and the sequester) should have subtracted 1.4 points from year on year RGDP growth through 2013Q4.
Figure 1 shows that the CBO were estimating that extending the reduction in the payroll tax and extending emergency unemployment benefits would increase year on year RGDP growth by 0.7 points in 2013Q4 (line five). Footnote 15 on page 11 indicates that approximately 80% of the budgetary effect of this component was due to the reduction in the payroll tax. Assuming the fiscal multiplier for the reduction in the payroll tax and emergency unemployment benefits is about the same, the economic effect of not extending the reduction in the payroll tax thus was about 0.56% of RGDP (i.e. 80% of 0.7 points).
Also, Figure 1 suggests that the economic effect of not extending lower tax rates for those with high incomes (the difference between line three and line four) is 0.1% of RGDP. The increase in income tax rates applicable to high income tax payers that went into effect under ATRA was actually somewhat smaller than what the CBO estimates were assuming, but probably not significantly enough to make it worth refining any further.
And lastly, Figure 1 shows that the CBO were estimating that eliminating the defense and nondefense spending reductions (i.e. the “sequester”) would increase year on year RGDP growth by 0.8 points in 2014Q4 (the sum of lines one and two). But the implementation of the sequester was delayed by two months. A crude adjustment to this figure may be obtained by reducing it by one sixth (two out of 12 months) or to about 0.67% of RGDP.
The sum of these three components totals about 1.4% of RGDP. Combining the CBO’s estimated effect of the three components of the fiscal cliff that actually did go into effect, with the CBO’s implied forecast in the absence of any of the components of the fiscal cliff of 2.4% RGDP growth, results in a forecast of 1.0% year on year increase in RGDP in 2013Q4.
A similar thing applies to the major private forecasters. (Sorry, no links, but some of this can probably still be googled.) The effect of the fiscal consolidation (again, the 2% payroll tax increase, the high income tax increase and the sequester) according to Bank of America, IHS Global Insight, Moody’s, Goldman Sachs, Morgan Stanley, Macroeconomic Advisers and Credit Suisse ranged from 1.0% to 2.0% of GDP, with the average estimate being about 1.6%. The baseline forecast (i.e. the RGDP growth without any components of the fiscal cliff) prior to the beginning of 2013 of these same seven private forecasters was for year on year RGDP growth of 2.0% to 3.5% in 2013Q4 with the average forecast being about 2.7%. Thus the average forecasted year on year RGDP growth in 2013Q4 adjusted for fiscal consolidation was about 1.1%. This is almost exactly the same as the CBO forecast that I’ve teased out above.
We now know that year on year RGDP growth in 2013Q4 was 3.1%, or significantly higher than what the CBO was forecasting, and higher than what most of the major private forecasters were estimating would occur without any fiscal consolidation at all.
Or, in plain English, taking into account the monetary policy offset, the fiscal multiplier still appears to be zero, even at the zero lower bound in interest rates.