The Fiscal Cliff

 

The so-called “fiscal cliff” – a term coined by Federal Reserve Chairman Ben Bernanke – refers to the combination of tax increases and spending cuts scheduled to be implemented automatically in January, 2013 without peremptory Congressional action.  As things stand now, the payroll-tax holiday will end, which means a tax increase for workers of as much as 2% of wages. Income-tax rates will also revert to pre-George W. Bush levels, raising taxes for nearly all taxpayers. Across-the-board cuts in domestic and, particularly, defense spending are triggered as well.  The spending cuts will go into effect because Congress couldn’t reach a deal last year during the debt ceiling crisis to reduce the deficit by at least $1.2 trillion. 

If Congress does nothing, the good news is that these three factors will likely drive the budget deficit to less than 1 percent of GDP by 2018 and then stay below that level through 2022, at which point demographics and health care cost issues lead it to start rising again.  The bad news is that these same three factors will be a major drag on an already weak economy, triggering a recession and the loss of about 2 million jobs, according to a Congressional Budget Office report issued in August.

Both presidential campaigns have been largely silent on the matter, in large part because few voters will like the plausible solutions. “The silence from both presidential campaigns and the Congress of the United States has been thunderous on this question,” says William Galston, a senior fellow at the Brookings Institution. “Nobody wants to talk about it because all of the choices are so difficult.”  The only (partial) mention of the issue during the presidential debates came during the final debate on Monday night when Governor Romney criticized half of the “sequester” – cuts to defense spending – while President Obama, in a surprise move, simply declared that the sequester “will not happen.”

Let’s hope he’s right.  But 74 percent of voters say neither candidate has done enough to inform the public about his plan for the fiscal cliff, according to a poll released last week by Center Forward.  And the consequences of any failure to cut a deal could be enormous.  Indeed, few people have made money betting against the stupidity of Congress.

Most experts expect that the sudden rise in taxes coupled with the significant spending cuts that characterize the fiscal cliff will have a harsh impact on an already struggling economy.  According to J.P. Morgan economist Michael Feroli, $280 billion would be pulled out of the economy by the sun-setting of the Bush tax cuts; $125 million from the expiration of the Obama payroll-tax holiday; $40 million from the expiration of emergency unemployment benefits; and $98 billion from Budget Control Act spending cuts.  In all, the tax increases and spending cuts make up about 3.5% of GDP, with the Bush tax cuts making up about half of that.

The CBO isn’t quite so negative.  Back in August, the CBO predicted that the pain would be short-lived and relatively mild pain. The U.S. economy would go into a shallow recession in the first half of 2013 — shrinking about 0.5 percent over the year — before roaring back. According to CBO, the economy would then grow at a rapid clip of 4.3 percent per year between 2014 and 2017. As a bonus, America’s short-term deficit problem would mostly vanish.

However, in Europe, heavy austerity seems to have crippled growth in countries like Spain and Greece. The International Monetary Fund recently released a report conceding that tax hikes and spending cuts can inflict far more damage on weak economies than previously thought.  Moreover, this report from the Levy Economics Institute called into question the CBO’s forecast that the U.S. economy can get back to full potential by 2018 even if we go over the fiscal cliff. It argues that there’s no way to make the numbers work unless you assume that U.S. households are about to go on an unprecedented borrowing binge.  Since every indicator suggests that U.S. households are actually rushing to pay down their debts right now, the CBO forecast appears dangerously optimistic.

Fed Chairman Bernanke has warned about the potential impact of the fiscal cliff. He gave a speech on the economy earlier this month and asked Congress to address the issue, albeit not yet.  Earlier this year Bernanke stated that “there is absolutely no chance that the Federal Reserve would be able to have the ability whatsoever to offset that effect on the economy.” The Fed, in the minutes of its April meeting, said that if lawmakers don’t reach agreement on a plan for the federal budget, “a sharp fiscal tightening could occur at the start of 2013.” Uncertainty related to the fiscal cliff “could lead businesses to defer hiring and investment” and weigh on economic sentiment, officials worried at the meeting. Agreement on a long-term plan could alleviate some of that uncertainty.

Former CBO Office Director Doug Elmendorf argues that fear of the fiscal cliff is already imperiling growth and Moody’s Investor Service warns that in the absence of policies that “produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term” they may downgrade the rating on U.S. sovereign debt.  BlackRock, the world’s largest money management firm, has warned that if a solution is not crafted, it may even be time for investors to head for the exits and turn to emerging markets instead.

On the other hand, a resolution of the fiscal cliff – which would likely include at least a partial extension of the Bush tax cuts, a patch on the Alternative Minimum Tax and extended unemployment benefits – could result in a significant market rally.  If such a resolution happens along with better Chinese growth than expected and no further disasters in the European debt crisis, the market upswing could be surprisingly strong.

Most experts assume that the U.S. would not be so foolish as to pull a “Thelma and Louise” and drive off the fiscal cliff.  Politicians in Washington, Wall Street assumes, won’t be that stupid, self-destructive and shortsighted as to let that combination of the expiration of the Bush tax cuts, the end of the reduction in Social Security taxes and the imposition of automatic budget cuts send the U.S. economy back into recession.

We can only hope.

2 thoughts on “The Fiscal Cliff

  1. Pingback: The Austerity Quandary | Above the Market

  2. Pingback: The Fiscal Cliff | Above the Market

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