The Fiscal Slope

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 next month 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 percent 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.

Based (at least) on the political theatre on offer by the Sunday news shows yesterday (Tim Geithner was seemingly everywhere), the movers and shakers assume that the U.S. would not be so foolish as to pull a “Thelma and Louise” and drive off the fiscal cliff.  In other words, politicians in Washington 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.

Moreover, a number of excellent commentators (led by Barry Ritholtz in The Washington Post; more here) are banging the drum for the idea that the fiscal cliff is more of a slope than a cliff and thus isn’t that big of a deal. Many (such as Eddy Elfenbein here) also insist that a deal pretty much has to happen.  I only disagree with the likes of Barry and Eddy with great trepidation, but I think they’re missing an important point.

While I think that the effects of going over the cliff (or down the slope) are likely to have a greater impact on a soft economy than Barry suspects and that the likelihood of a deal is somewhat less than Eddy believes, my primary and overall concern relates to something barely mentioned in the day-to-day coverage.  Notice how the Obama administration’s opening bid last week in negotiations to avert the alleged crisis included a demand for authority unilaterally to raise the U.S. debt ceiling. 

The debt ceiling is where the real fight will be and where the real risk lies (note Bruce Bartlett’s careful analysis here).  The CBO estimates that given current spending and revenue trends, the existing debt ceiling will be reached before the end of the year.  Since far too many Republicans seem willing to allow the federal government to default on its debt in order to exact further concessions on spending and entitlements (recall what happened last summer), I think the overall risk to the markets remains substantial. 

The overall strength of the U.S. economy and (especially) our ability to print money means that the likelihood that owners of U.S. debt won’t get paid should be essentially nil.  However, markets generally do a dreadful job of analyzing political risk.  One’s ability to pay is much easier to deal with than one’s willingness to pay. Such an unwillingness to pay — even if the default is only temporary and “technical” — could have enormous repercussions with respect to U.S. borrowing rates as well as to the overall strength of what is (for now, at least) the world’s reserve currency. The U.S. dollar has remained the world’s default currency and U.S. Treasuries have remained the world’s default securities largely because investors have always been entirely confident that the money invested there was safe from political machinations.  I don’t think it entirely far-fetched to wonder if those days may be numbered.

I hope Barry and Eddy are right.  But I’m plenty nervous just the same.


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