This week, RGE tracked a series of events that revealed the Obama administration’s juggling act: an effort to maintain growth, tame the fiscal deficit and garner the congressional support needed to implement policy. Democrats’ loss of the Massachusetts Senate seat raised questions about President Obama’s ability to take forward reforms on financial regulation, fiscal austerity and health care. Though Obama’s response was prompt and decisive, with proposals for financial-sector reforms that surprised markets and plans to address the ballooning fiscal deficit, his waning political capital will stand in the way of achieving his fiscal, social and economic goals.
Obama on January 14 proposed a Financial Crisis Responsibility Fee, a tax levied on the non-deposit liabilities of the largest financial institutions to cover the expected losses from the TARP program. The tax, expected to be imposed for at least 10 years, with an assessment of 15 basis points per year, would raise US$90 billion over that period and approximately US$117 billion over 12 years. Only firms with consolidated assets greater than US$50 billion would be affected, and over 60% of revenues would most likely be garnered from the 10 biggest firms. U.S. subsidiaries of foreign firms would also be subject to the fee.
Among the tax options on the table, which also include a global financial transaction fee (“Tobin Tax”) and a Bonus Tax, a risk-based fee is the most efficient solution. As previously advocated by RGE Chairman Nouriel Roubini and Lasse Pedersen in this op-ed, a similar systemic risk levy to finance a “resolution fund” is being considered in Congress as a way to internalize potential bailout costs stemming from too-big-to-fail institutions. Obama’s risk-based fee model is gaining traction at the international level, as this Critical Issue details. At the Davos Forum, some leaders of the largest financial institutions have voiced support for the proposal. Jaime Caruana, the chief of the BIS, stated that the most realistic way to institute a global levy would be to implement a similar levy in Europe. Moreover, at the G20’s request, the IMF is producing a study on the various ways in which the financial sector could help recoup the costs of public-sector crisis support.
On January 21, the president proposed the “Volcker Rule,” named after former Fed chairman Paul Volcker, one of the biggest proponents of Glass-Steagall-type restrictions (although his current proposal—endorsed by the president—does not call for a separation of commercial and investment banking activities). The president’s proposal would put limits on the size and scope of the U.S. banking sector in the interest of addressing risk management and conflict-of-interest concerns. According to Volcker, the rationale for limiting the size of institutions arises from the vital capital intermediation and payment system functions they provide for the real economy. The complexity that arises from the combination of these activities is reason enough to limit each institution’s size, to ensure that an individual failure would not disrupt the economy. For the same reason, he argues, leveraging the risk inherent in commercial banks’ maturity-transformation business with proprietary trading activities is not warranted and should not be backstopped by the safety net provided to ensure deposit-taking institutions’ core activities. The same reasoning applies to bank ownership of private equity and hedge funds, with conflicts of interest an additional aggravating factor.
In Dr. Roubini’s view, the new Volcker Rule is a step in the right direction. More radical reforms, like breaking up too-big-to-fail financial firms and returning to Glass-Steagall-type restrictions, that are needed to stave off asset bubbles and tame systemic risk may be politically difficult to implement, he warns.
This month, the Obama administration released its FY2011 budget, which forecasts fiscal deficits of US$1.55 trillion (10.6% of GDP) and US$1.3 trillion (8.3% of GDP) for FY2010 and FY2011 respectively. To support economic recovery in the near term, the administration plans to increase spending on several stimulus measures: extending unemployment benefits and health-care subsidies for unemployed workers, providing tax and credit incentives for small businesses to invest and hire workers, extending payroll tax cuts for the middle class and increasing funding for states, infrastructure and transportation. Meanwhile, the administration plans to begin to reduce the fiscal deficit in 2012 and bring it below 4.0% of GDP by 2014 by adopting fiscal consolidation measures and reducing the primary deficit through raising taxes on high-income households and investors and cutting spending on health care and discretionary programs.
These proposals fall short of aggressive fiscal reforms, and the fiscal deficit is likely to remain near US$1 trillion and exceed 5.0% of GDP over the next decade (and trend higher thereafter). Near-term spending on fiscal stimulus and defense will remain high at least until 2011, as Obama’s proposed three-year freeze on discretionary spending excludes defense and entitlements. A sluggish and jobless economic recovery and weaknesses in the financial and household sectors will keep revenues subdued and constrain tax hikes. Rather than yielding savings, as projected by Congress and the administration, the health-care reform legislation will burden the fiscal deficit over the next decade. Health-care mandates and subsidies will raise government spending, while cost savings from the proposed reforms will be small and accrue only in the longer term. The elimination of the “public option” might reduce fiscal costs, but the lack of it will keep insurance premiums high.
Obama simply lacks the political support to implement aggressive fiscal reforms. The Senate recently voted against Obama’s proposals on spending freezes and the establishment of a fiscal commission, whose role would be to send fiscal reform legislation to Congress that would have to be voted on or thrown out without the possibility of amendments. Moreover, if policymakers extend the 2001 and 2003 tax cuts beyond 2011, when they are scheduled to expire, the impact on the fiscal deficit and U.S. fiscal credibility would be immense. Washington has not signaled strong support for wider tax reforms, such as introducing a value-added tax (VAT).
Despite the ticking fiscal bomb, mid-term and presidential elections in November 2010 and 2012 respectively will further constrain political will to undertake necessary reforms. With sub-par economic recovery and an unemployment rate above 9.0% forecast for 2011-12, the Democrats, grappling to maintain power, are unlikely to approve spending cuts, while the Republicans, seeking to revive their prominence, will be unyielding on tax hikes. Even if Obama manages to establish a fiscal commission by executive order, Congress will be wont to reject any radical fiscal reform proposals.