The debt ceiling deal: When bad politics triumphed over sound economics

In the debate over the debt ceiling, bad politics triumphed over sound economics. This wasn’t the first time, and unfortunately it won’t be the last.

By Richard Schiming

Published in the Mankato Free Press, Sunday, August 14. (NOTE: This important article is published in its entirety here because it is not available on the public Free Press website.)

Richard Schiming is a Minnesota State University Mankato economics professor. He has a Ph.D in economics from The Ohio State University and has expertise in the fields of money and banking, macroeconomics and economic education.

What will be the economic impact of the debt ceiling legislation?

We have already seen the impact of that political circus on the credit rating of the United States government. But the worst may be yet to come.

Make no mistake about it: that legislative agreement to curb the deficit will ultimately punish the economy and hurt job growth. The possibility of a double dip recession just increased. Whenever the federal govern­ment reduces its spending, aggregate demand falls and the economy weakens.

If you wish to reduce federal budget deficits, the choices are cutting government spending or raising taxes. Which one of those policy options would have the lesser adverse impact on our economy? After all, a dollar reduction in government spending or a dollar increase in tax revenue would both have the same one- dollar impact on reducing the federal deficit.

The answer to that question depends on the multiplier process, the ripple effect that fis­cal policy has on the overall economy. Each time government changes its taxing or spending by a dollar, there is a further impact on overall economic activity.

Estimates by the non- partisan Congressional Budget Office show that a one- dollar change in government spending can cause overall spending in the economy ultimately to change by as much as $ 2.50. A one- dollar change in taxes to higher income individu­als would change overall spend­ing by at most 50 cents.

Additionally, the impact of tax changes takes longer to ripple through the economy than does changes in government spending. A one- dollar change in govern­ment spending immediately enters the economic blood­stream. Tax changes take time to affect consumer and business spending decisions, delaying the impact on the overall economy.

What does all this mean for fiscal policy? When you want to stimulate the economy, the preferred strategy for stepping on the fiscal accelerator would be to use only increased government spending. Those spending increases would have a quicker and stronger impact on growing the economy than any tax cut could.

If you want to step on the fiscal brakes to reduce the deficit, you could choose to reduce government spending. The overall economy would shrink by much more than a dollar for each dollar of reduced government spending. The adverse impact on economic growth and jobs would be quickly felt.

On the other hand, if you increase taxes by a dollar to reduce the deficit, the pain for the overall economy would be substantially less in terms of lost income and the negative impact on jobs and economic growth would take longer to occur.

If the current aim of fiscal policy is to reduce deficits and we want to do the least damage to our struggling recovery and weak labor market, the best policy would be to have most if not the entire deficit reduction package composed of tax increases.

We are now contemplating reducing the federal budget deficit by cutting only government spending. That would impose the greater drag on economic growth and employment. Yet we are ignoring the tax increases that would do the same job on the deficit without as many negative macroeconomic impacts.

In the debate over the debt ceiling, bad politics triumphed over sound economics. This wasn’t the first time, and unfortunately it won’t be the last.