06/21/2013 11:24 am ET

Austerity: Pain Without Progress

A Closer Look at Fiscal Policy
Fiscal Drag

The Congressional Budget Office (CBO) estimates that tax hikes and sequestration (mandated, across-the-board spending cuts) will shave about 1.5 percent from overall economic growth in 2013 and are likely to remain a drag on growth in 2014. The result is an economy that continues to grow a little north of 2 percent instead of closer to 4 percent, or "escape velocity." Unemployment, in particular, could become more of a structural than a cyclical problem as many of the ranks of the long-term unemployed find their skills are obsolete and give up.

Much of the fiscal drag results from indecision rather than decisions by Congress. Sequestration was designed to be so damaging that Congress would rather come up with a sustainable, long-term budget plan than suffer consequences that will kill sacred cows on both sides of the aisle. Congress failed to act; sequestration kicked in; spending cuts began.

Moreover, sequestration does nothing to address the elephant in the room: upward pressure on entitlement spending and the widening deficit that an aging population will cause over time. CBO estimates that recent narrowing of the deficit could reverse itself as soon as 2016, when increases in entitlement spending overtake mandated cuts. In response, interest rates will eventually spike, as investors in U.S. Treasury debt begin to question our credit worthiness as a nation.

This report takes a closer look at fiscal policy, how we got here, the effects on monetary policy, and, the risk that gridlock and inability to set a real budget will not only dampen our growth potential, but smother it with a full-blown fiscal crisis. For now, our political system appears to be broken, with our elected officials rewarded for winning political, not economic, battles. It's almost as if we have decided to deliberately ignore the lessons of our own Great Depression and Europe's debt crisis.

How Did We Get Here?

Much has been written in recent years on the polarization of Congress, the breakdown of the political system and the gridlock that has emerged. The results of the 2012 election perpetuated a trend that started in the 1980s and intensified in the 1990s and 2000s. The views I have gathered here are from a variety of sources, all of which attempt to rise above partisan politics.

Read all of Themes on the Economy, including this excerpt.