A balanced budget amendment would be extraordinarily dangerous for the economy

The House is set to take up a balanced budget amendment this week, which would limit federal spending in each fiscal year to federal receipts in that year. Putting aside for a moment the chutzpah of House Republicans trying to pass a balanced budget amendment (BBA) just a few months removed from their passage of a $1.5 trillion tax cut that went largely to the richest households and big corporations, the simple fact is that the economic consequences of a balanced budget amendment range from extremely bad to catastrophic. The reason for this is that a BBA would amplify any negative economic shock to the economy and would thereby turn run-of-the-mill recessions into disasters.

When the economy enters a recession, government deficits increase as tax revenues decline and government spending on programs such as unemployment insurance increase. These “automatic stabilizers” are incredibly important as they cushion the blow to the economy from a recession. For example, researchers at Goldman Sachs found that the shock to private sector spending from the bursting of the housing bubble was larger than the shock that led to the Great Depression of the 1930s. Given this larger initial shock, why didn’t we have another Great Depression, with unemployment rates approaching 20 percent and beyond, in 2009–10? The simple reason is that the mechanical increase in the deficit from tax reductions and increased transfer payments absorbed a lot (not enough, but a lot) of this shock, and automatic stabilizers were either non-existent or a lot smaller in the 1930s. Having these programs in place to absorb recessionary shocks is one of the great economic advances of the past 80 years—and getting rid of them by imposing a BBA makes as much sense as outlawing computers or antibiotics. To comply with a BBA as a recession approached, Congress would have to offset any mechanical increase in the deficit by raising taxes or cutting spending. The increased taxes or spending cuts would further drag on the economy, raising the deficit again and requiring still further tax increases or spending cuts. This vicious cycle would amplify the damage to the economy. Essentially this vicious cycle would lead to a large increase in the fiscal multiplier, with each dollar in spending cuts leading to output losses of about $2.50.

The Federal Reserve could try to counteract this drag on the economy by cutting interest rates. But the extent to which they would be able to mitigate the damage may be extremely limited, for a couple of reasons. First, while the Fed can certainly restrain growth by raising interest rates, spurring growth by cutting rates is often ineffective; a dynamic often referred to as rate cuts akin to “pushing on a string.” Further, with current chronic downward pressure on aggregate demand, so-called “secular stagnation,” characterizing the U.S. economy in recent decades, it is likely that the Federal Reserve would be constrained by the zero-lower bound (ZLB) on interest rates—as it was during the Great Recession. Since interest rates cannot be moved (for too long or too far) below zero, when the Federal Reserve hits the ZLB they will be unable to offset any further drag on the economy through conventional monetary policy.

How big a deal is this problem of a BBA amplifying negative economic shocks? We can assess this by examining what would have happened if we had required balanced budgets throughout the Great Recession. Between 2007 and 2009, the federal deficit increased by about 8.7 percent of gross domestic product (GDP). As we explained above, with the Fed hamstrung by the ZLB as early as late 2008, these cuts would have hit the broader economy with a fiscal multiplier of 2.5. This means that if we had been forced to balance the budget in the face of the shock that led to the Great Recession, then GDP would have declined by a staggering 22 percentage points. With unemployment peaking at 10 percent during the Great Recession, Okun’s law implies that a balanced budget would have caused unemployment to peak instead at about 21 percent.

The private economic forecasting firm Macroeconomic Advisers likewise found that had a balanced budget amendment been in effect during fiscal year 2012, “the effect on the economy would be catastrophic.” With the Fed still constrained by the ZLB, they estimated that the unemployment rate would have doubled from 9 percent to 18 percent.

To address this problem of making recessions into disasters, the bill the House will vote on next week allows the Congress to override the balanced budget amendment with a vote of three-fifths in both houses of Congress. But this provides little practical reassurance. With the Fed stuck at the ZLB, government fiscal austerity throttled the recovery from the Great Recession for almost a decade, and this could have been reversed at any time by a congressional majority. This recovery was throttled for transparently political reasons—Republicans in Congress seemed to think a weak economy helped their re-election chances. Why then should we assume that by adding further constraints a future Congress won’t throttle the next recovery (simply through inaction) when they find it politically useful?

Republicans currently control both houses of Congress and the presidency. They could balance the budget if they wanted to. Instead, they have shown themselves more interested in cutting taxes for the rich. Likewise, any future Congress that wants to has the power necessary to balance the budget. It is deeply strange to think a constitutional amendment is required to do so. This is clearly a political stunt. It may be unlikely to become the law of the land, but the damage it would do if it did become law is large enough that we should be awfully worried that this week’s vote is even going to happen.