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Driving off the fiscal cliff?

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As many predicted, the “fiscal cliff” negotiations are going down to the wire. Congress and the President have until the end of 2012 to agree a deal that would prevent tax rises and budget cuts. But this brinkmanship does not find Americans sitting on the edge of their seats, eagerly awaiting the outcome. The sight of elected officials frantically negotiating their self-imposed deadline, at a time when they would normally be taking a holiday vacation, is more farce than drama, and provides a further reason for people to despair about the state of the political class.

The fiscal cliff has its immediate roots in the outcome of the political conflict over raising the US federal government’s debt ceiling in the summer of 2011. Republicans had refused to approve an increase in debt ( move that some have described as an unwillingness to pay a credit card bill after agreeing to use the credit card), as a lever for cuts in spending. The resolution was the Budget Control Act of 2011, which called for immediate cuts, as well as further $1.2 trillion in automatic across-the-board reductions in expenditure on defense and other areas on January 2, 2013, unless that amount of savings was agreed to be found elsewhere. The New Year will also see the expiration of the tax cuts implemented under President George W. Bush, which were due to lapse in 2010 but were extended for two additional years.

The thought in August 2011 was that the combination of automatic cuts and large tax increases would force the two parties to make a deal. But what it really represented was an abdication of responsibility; we can’t compromise, so let’s just kick the can down the road. The August 2011 debt-ceiling talks were an own goal that embarrassed the political class, as Standard & Poor’s downgraded US debt, and the stock market tanked (for my take at the time, read this and this). By setting a fiscal cliff, officials were just creating the circumstances for a repeat, this time for higher stakes.

All this said, it is important to keep the negotiations in perspective. There’s a lot of hype and misinformation bandied about.

On one hand, the fiscal cliff is not as serious as the doom-mongers make out concerning the short-term consequences. It’s true that a majority of economists say that fiscal implications of cutting the deficit in half in one year could tip the economy back into recession. While there’s no doubt that a fiscal contraction would have some impact on the economy, there are good grounds to be skeptical. Tax increases will not, in themselves, undermine the economy; for instance, the Clinton administration raised taxes in 1993 and then saw growth follow. And the cuts in spending are relatively small. A strong economy would withstand such fiscal changes; a weak economy would go into recession without them happening.

On the other hand, the deficits and debt situation of the US federal government is more serious in the medium to long-term than many are willing to face up to. With all the talk about the fiscal cliff and a potential recession in 2013, the more substantial problem of growing debt is not being addressed.

David Wessel summarizes the longer-term issues raised by the federal budget in his very useful and clear book, Red Ink (2012). Some key points that Wessel makes:

  • Measures adopted by George W. Bush administration shifted the US from surplus to deficit, including tax cuts and higher spending on two wars (Iraq and Afghanistan) and Medicare drug benefit. Furthermore, the recession and financial crisis of 2008-2009 added to deficits, due to (1) a reduction in tax revenues; (2) automatic increases in benefits, such as unemployment benefits; and (3) special bailout spending
  • Therefore, President Obama did inherit an economic crisis and deficits. But his administration has added to the deficits – mainly via the nearly $800bn in stimulus spending in 2009, plus other spending, as well as agreeing to an extension of the Bush tax cuts. The federal government deficit was $6.3 trillion and 45% of GDP when Obama entered the White House in January 2009, and, according to Wessel, was $10.6 trillion and 70% of GDP in February 2012 (it’s now $16.3 trillion, according to the Treasury’s “Debt to the Penny” website)
  • Based on the current trajectory, the US government debt will reach 100% of GDP, perhaps within ten years, maybe sooner. Unlike today’s situation, that level of debt would indeed be at crisis levels
  • About two-thirds of spending is on Social Security and healthcare programs (Medicare and Medicaid), and the costs for both of these are rising and are projected to increase further as the Baby Boomers retire. Therefore, any attempt to reduce spending has to address these programs
  • Of these, health is the number one cause of growth in spending. (I would add that Obama’s “historic” changes to the health system did not adequately address its rising costs)
  • With large debt, interest costs become larger (and are likely to become larger when interest rates, which have been at historic lows, rise). In 2011, the US government paid more than three times in interest than it spent on all non-defense research and development (such as medical research and space exploration)
  • However, major cuts in spending and large reductions in interest payments are unlikely to be sufficient to close the gap. Taxes will need to rise, and ending the Bush tax cuts would be a big help (but neither Democrats nor Republicans countenances such an increase in the immediate future)

From the point of view of the economy, the main issue is to restore growth. Growth is key to restoring fiscal health, as it will increase revenues and reduce deficits. Projections of high debt levels over the next decade assume modest growth during that period, but we should be more ambitious than that. Despite the parlous state of US finances, even an increase in certain spending  that would assist growth – for example in R&D and infrastructure – would be justified, because the net effect would be to lower deficits over time.

However, an appropriate focus on growth does not mean that there is no fiscal problem at all in the US. Keynesians such as Paul Krugman are wrong to argue that all government spending has benefits, and that deficits will take care of themselves. Only certain government activities are likely to support productive industry and economic growth; much of the short-term counter-cyclical measures that Keynesians call for have just temporary effects. Furthermore there are spending issues that the US needs to address. There is waste in welfare programs for individuals (a jaw-dropping one-in-seven is now on food stamps) as well as for corporations (oil corporations, farms, green ventures, among others). Defence spending does not need to be at historically high levels. And, as mentioned above, the two major structural issues to address are Social Security and Medicare/Medicaid.

The irony is that, for all of the talk of going over a fiscal cliff, our politicians are not really dealing with the big budget issues. The $1.2 trillion in cuts they are haggling over – which are to be implemented over 10 years, remember – is a drop in the ocean of debt. Even if they reach a last-minute agreement to avoid the cliff, it will still be an exercise in delaying the day of reckoning.

Knowing that, it is hard to find comedic value in Washington's farcical scrambling before the ball drops in Times Square.

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