Chad Stone is chief economist at the Center on Budget and Policy Priorities.
No one knows for sure what will happen to the economy if the president and Congress can't agree on what to do about the "fiscal cliff" by December 31. I've argued that the economy can withstand a brief period in which higher tax rates and deeper spending cuts are on the books as long as that situation does not continue for months. Neil Irwin in the Washington Post offers a different view, saying the economy (probably) can't survive even a short brush with austerity.
That "probably" is a pretty important caveat in Irwin's argument, however. To his credit, he acknowledges up front that normal analytical tools say it "won't be very bad at all" if we have only a few weeks of "automated austerity" before policymakers cut a deal to prevent the full effects of the fiscal cliff tax and spending changes from playing out and likely throwing the economy into a recession. He even lays out the analytical reasons why many of us believe the economy would not be seriously damaged if policymakers can't reach agreement until early in 2013. But he then dismisses this conclusion out of hand, calling the application of normal analytical tools "a naïve way of viewing the situation."
Instead, Irwin appeals to "the real ways that markets and psychology interact with economic forces." But the scenario he lays out to illustrate how the real world works is one in which policymakers show no signs of coming to agreement and ongoing uncertainty roils financial markets. I agree: Over time, in the absence of any signs of an agreement, a falling stock market could hammer households' wealth and confidence and business' willingness to invest, just as those who warn about the economic effects of going over the fiscal cliff fear.
But that's a different scenario from one in which policymakers let the fiscal cliff changes take effect for a few weeks while negotiations continue and then strike an agreement that replaces them with a different set of policies that do not impose substantial immediate austerity. That's the scenario those of us who rely on normal analytical tools envision. When we introduce market reactions and psychology into the mix, it's to argue that it might be necessary to go over the fiscal cliff to galvanize policymakers into quickly working out an agreement.
Ironically, Irwin makes a version of that argument himself, suggesting that, "If the talks are going off the rails in the final days of December, with no accord in sight, it may well be the markets, looking forward to the ill-effects to come, that provide a certain focus for recalcitrant lawmakers." What normal analytical tools tell us is that it makes very little difference to the economy whether the deal comes in December or January.
It can, however, make a critical difference in the dynamics of the negotiations. Until December 31, those who favor extending the high-income Bush-era tax cuts for high-income taxpayers—despite a lack of popular support and evidence that they provide little economic benefit—can hope that fear-mongering over the economic consequences of the fiscal cliff will allow them to prevail yet again. After January 1, those tax cuts will be gone and policymakers can focus on measures that support the recovery in the short term while providing a framework for meaningful deficit reduction over the longer term.