Falling off the Cliff

Ben Bernanke certainly has a way with words. During his testimony before Congress in February 2012, he warned legislators that “a massive fiscal cliff of large spending cuts and tax increases” would hit the United States on 1/1/2013. The phrase seemed tailor made for the press and TV networks who like to explain complex economic conundrums with pithy sound bites. As such if you haven’t already, expect to see multiple articles every day from now till the new year on the fiscal cliff. In the US, depending on political persuasion, the fiscal cliff is regarded by some as shock therapy needed to get America’s long term financial situation on track; and by others as another example of republican intransigence which will cause pain to millions of Americans.

So what is the fiscal cliff?

 In a nutshell the phrase describes a combination of tax increases and spending cuts that will take effect gradually from 1/1/2013. Tax rates for top earners in the US will revert to 39.5% (the rate under the Clinton administration) and a variety of US taxes (payroll tax for example) will go up as well. Almost 90% of Americans will experience some sort of tax increase. On the spending side, across the board cuts to federal programs and defense spending will total around $90B. On the whole around $600B in tax increases and spending cuts is what the Congressional Budget Office (CBO) estimates as the effect of the fiscal cliff over 2013.

 

How the US got here

The fiscal cliff is a direct consequence of the debt ceiling drama enacted over the summer of 2011. The US government borrows under authority of the US congress to pay for government spending. Congress approves a set amount of debt that the US treasury can issue over a certain time frame. Republicans in Congress agreed to raise the debt ceiling by $2.1T with the caveat that any further debt ceiling increases be preceded by tough spending cuts and tax increases. This agreement formed the basis of the Budget Control Act signed by President Obama. In August 2011, Standard and Poor’s downgraded the US credit rating which led to great market convulsions. Stocks tanked and ironically US debt saw great demand on safe haven buying by investors. The effect of S&P’s credit downgrade was the US experiencing the lowest government bond yields ever.

Fast forward a year and a half and the US Treasury expects to hit the debt ceiling again before the end of 2012. With an emboldened President Obama promising to push for tax increases and a restive Republican party vowing not to increase taxes the stage is set for another long drawn out battle like the one in 2011. The consequences of inaction are quite high. The CBO and a multitude of economists expect US GDP to actually contract or rise by only .5% in 2013 if the full provisions of the fiscal cliff go into effect. Unemployment is expected to rise to 9%. On the other hand the deficit would fall to $200B by 2022 and the debt to GDP ratio would fall to 58% from a $1.1T deficit in 2012, and a debt/GDP ratio of close to 70% today.

What does all of this mean?

Apart from providing endless amusement to foreigners on the inanity of the US political system, the debt ceiling/fiscal cliff issue centers around a very few fundamental issues in American politics. The issues relate to the fairness of taxation, the role of government and what type of country people want America to be. Depending on where people stand on the political spectrum, people come up with different solutions. The rich are taxed too little some say, while others say the federal government is addicted to spending. The US needs higher taxes to pay for Medicare and Social Security. No say others, the US needs to lower spending on Medicare and Social Security. High indebtedness will turn us into Greece say some. The US is the only safe haven in the world so we can get away with issuing as much debt as we want say others.

Offering no political opinion here’s my best guess for what happens over the next few months. The Republicans and the Democrats continue to play a game of chicken till the end of the year.  With a new congress to be sworn in early next year most probably we go into the New Year without a real deal on the fiscal cliff. Expect strong rhetoric and doomsday scenarios. In true Washington fashion we will probably get a stop gap bill which raises some taxes and cuts some spending with promises of a ‘real comprehensive solution’ down the road. The uncertainty generated by this drawn out process will deter businesses from taking any long term decisions which is detrimental to the US economy.

Even if there is a short term solution in the next few months, the long term issue remains unresolved- How does the US plan to tax its citizens to pay for services, and how the Federal debt should be managed to meet this need. Here is another nifty chart that shows how the CBO’s economic projections changed through 2001-2011.

And here is another chart from the Heritage Foundation highlighting the problem faced by the US. Even if the fiscal cliff provisions were to go into effect the US would still need to issue debt to finance deficits.

Source: Congressional Budget Office.

As I mentioned before there are a whole range of voices in the US regarding this issue. From one extreme (no debt – balance the budget) to the other (more important to grow the economy- debt not an issue).  As long as the US remains the dominant superpower and the US $ retains its role as the world’s reserve currency, the US’s ability to issue debt at a low cost will not be in doubt. But there might come a day when the US finds itself without buyers for its debt and then it will have to make hard choices.

Posted in Blog.

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