The Fiscal Bunny Slope – Whether a Patch or a Grand Bargain, there ain’t gonna be no cliff.
The Fiscal Bunny Slope – Whether a Patch or a Grand Bargain, there ain’t gonna be no cliff.
Just call me Dr. Pangloss; in fact, a few weeks ago someone did just that when I said among other things we would see a Fiscal Bunny Slope, not a Fiscal Cliff. To be sure, there will be some nail biting days for risk assets while negotiations and posturing continue. Obama may even take a page from the TARP playbook and risk a negative reaction from Wall Street as a negotiating point. Our analysis estimates that at the end of the day taxes will rise on those in the top income bracket, (dividend interest will stay where it is) and some programs will end or be cut resulting in a $140-160bn combination of tax increases/spending cuts – a Fiscal Bunny Slope compared to the full Fiscal Cliff. This will slow growth in the first half of 2013 to 1.3%-1.8% but it will not be a fall off the cliff. Addressing entitlements spending will slightly reduce economic activity in the near term, but could boost activity longer-term if deficits are gradually reduced and the longer-term entitlement obligations are put on a more sustainable trajectory.
The Fiscal changes that could take place are comprised of automatic spending cuts, repeal of the Bush tax cuts, the end of the payroll tax cut and other miscellaneous items such as new tax hikes linked to the affordable care act and the expiration of extended unemployment benefits. The total combination of increased revenues and reduced expenditure is estimated at $825bn, with $300bn associated with the Bush tax cuts (see table below). Yet despite all of these spending cuts and tax increases the lion’s share of the fiscal burden, that which goes to support the entitlements of Social Security, Medicaid and Medicare, is the real bugbear of the US fiscal situation. Left unchecked these obligations will continue to grow in the coming years, crowding out all other government spending. Boehner’s Dec 3rd letter to Democrats and the White House proposes $900bn in curbs on entitlement spending yet the White House has not exactly embraced it. As we discuss in more detail below, touching entitlements is something both parties have trepidation over because cutting these programs is, well, unpopular with both the Tea Party and many Progressives. Economists and business leaders would be relieved if the pending spending cuts and tax increases were reduced in return for a Bowles-Simpson type agreement that dealt with growing entitlement spending. But as we all know, this is easier said than done. So why do I see a Bunny Slope and not a cliff? There are three main reasons:
- The stabilizers were put in place to force a compromise on the larger budget issues of tax base, future liabilities and entitlements. The goal was to force an outcome so unappealing that it would bring about a negotiation so that said outcome could be avoided.
- Neither Republicans nor Democrats want a recession. The OECD just forecast member country growth at 1.4% for 2013. A growth prescription is needed and cyclical fiscal adjustments are a recession prescription. If you are unsure about this please consult the European Recession Manual. Yes, long-term solutions to entitlements are needed, but much of our current budget deficit is cyclical. We need to get growth going which will make it easier to deal with the structural budget problems.
- President Obama is in a strong negotiating position not just because he won the election but because of points one and two. All the president has to do is let the Bush tax cuts expire in 2013 and then propose a bill that cuts taxes for all but those in the top bracket and it will be up to the Republicans to vote it down. Doing so would be widely unpopular. It is no wonder that we now have key Republicans saying they will consider revenue increases. Obama is playing hardball, because he has the better negotiating position. Yet Obama would be wise not to completely reject Boehner’s latest proposal which does eliminate many loopholes for upper income earners that would actually make the tax system less cumbersome. Yes it would reduce headline tax rates on the wealthy, but overall income from higher earners who itemize deductions would increase and effective tax rates would rise.
A high stakes game of chicken is unsettling for the markets but for this very reason it is an effective, if nerve racking, way to get things done. Let’s remember back to the days in August of 2011 when the Fiscal Cliff was first conceived. It was a set of handcuffs if you will. Handcuffs that were self-imposed by a congress that realized an increase to the debt ceiling for the 74th time since 1962, (10 of those increases have taken place in the past 10 years) was getting us very close to unsustainable debt levels because the debt ceiling has no teeth. Despite the fact that both the Domenici-Rivlin Plan and the Simpson-Bowles plan never made it into legislation, some consensus is forming that spending cuts and revenue increases are needed if we are to have any hope of solving our long term entitlement obligations. This realization is slowly occurring to the US population who are now searching the term fiscal cliff at a growing rate on Google.
Thus, in return for increasing the debt levels, deficit/debt hawks put in place measures that are unpalatable to both Democrats and Republicans in the hopes it would force both sides into a so-called Grand Bargain. The week after the election I spent time in Washington DC meeting with key players from both sides of the aisle. I also attended the excellent Guggenheim post mortem election conference. And just like my take-aways from Glenn Hubbard and Gene Sperling last month, my belief is stronger now than ever, that at the end of the day cooler heads will prevail. A Grand Bargain will be struck that solves our long-term fiscal obligations, perhaps it won’t kick in just yet, but it will be a bargain nonetheless and a Fiscal Bunny Slope to be sure.
When looking at the Fiscal Bunny Slope there are three components to consider, the economic impact, public opinion and the likely outcomes. The first two greatly influence the third.
The direct loss of income due to tax increases and spending cuts that we outline in the table above have multiplier effects that could cut output by a wide range depending on the multipliers used. The CBO estimates a 1.3% fall in the first half of 2013 if the full fiscal cliff occurs and Strategas Research estimates a more draconian 8% fall in Q1 followed by a 6% fall in Q2. In either case, if we go over the cliff, there’s no doubt the fall in economic output will result in a recession that would negate much of the deficit savings – as GDP falls so does tax revenue and so does the denominator in the debt to GDP ratio. At the Economic Club of New York the week before last, Fed Chairman Bernanke told the audience there would be a benefit to reaching an agreement saying “A plan for resolving the nation’s longer-term budgetary issues without harming the recovery could help make the new year a very good one for the American economy.” He was talking not just about avoiding recession but about the positive impact avoiding a cliff might have on economic activity. While demand is still weak and disposable income only expanded by 2.1% in real terms in Q3, there are some sectors that are showing signs of life such as construction and oil and gas production. So much in economics is momentum or trend driven; if the previous periods show an increase there is a greater chance the subsequent period will too. Engineering a fiscal bunny slope would cause some slowing of momentum, but the psychological benefit of avoiding the cliff could well offset this. Businesses are indicating they are delaying purchases of equipment as evidenced by the responses to the December ISM survey and the -2.7% fall in capital expenditure in Q3. Lawmakers should also be aware that kicking the can down the road just prolongs the malaise. Doing nothing to solve the question of how we deal with long-term structural issues will keep corporate activity muted.
According to an October 12, 2012 Pew Research study 64% approve of tax increases on those earning over $250,000 and 58% approve of limiting corporate tax deductions. While not yet a majority approve (only 47%) of doing away with the mortgage interest deduction (as was proposed in Bowles-Simpson), only 44% disapprove of this measure. The mortgage interest deduction impacts the less than 30% of taxpayers who itemize and who also have mortgages so I suspect this approval number be higher with better education. On the longer-term issues the outlook is less encouraging. According to Pew there is resistance to making changes in Social Security and Medicare to reduce the debt and deficit: 57% oppose raising the amount Medicare recipients contribute to their health care, while 56% disapprove of gradually raising the Social Security retirement age. As for means testing, 49% approve of reducing Medicare benefits for higher-income seniors while 47% disapprove of such measures.
In terms of working together the latest Pew Research poll suggests 67% of all voters want Republican leaders to work with Obama and 72% want Obama to work with Republicans. Among Republicans surveyed, 50% want Republicans to stand up to Obama and among Democrats, 42% want Obama to stand up to Republican leaders. 68% of voters say the effect of automatic tax increases and spending cuts will have a major effect on the economy and 62% say that effect will be mostly negative. So while Obama may have the better negotiating position in terms of an election win and an expiring set of tax cuts that will allow him to play hardball if no compromise is reached before January 1, 2013, such a strategy could actually backfire in terms of popularity and effectiveness. The country want the Democrats to work with Republicans and the majority of the population knows the fiscal cliff will have a major negative effect on the economy.
So why am I so optimistic? While there are many things congress does not do well when compared to the best run corporations or other models of efficiency, it does actually work the way it was designed, that is inefficiently. The founding fathers set up a system with checks and balances to limit the government’s powers for which they were prepared to sacrifice effectiveness. Yet time and again, when needed, issues of great import galvanize our legislators into decisive and effective action. The best action seems to come from a divided government, one where the President is from a different party than the one controlling either the House of Representatives or the Senate.
Voices from the right, such as Glenn Hubbard, Romney’s economic advisor, or Bill Crystal, or even Boehner himself, are all suggesting that the Republicans must consider increased revenue as part of their plan. A September 2012 survey of NABE economists show that 45% believe the best way to reduce the federal budget deficit is via a combination of spending cuts and revenue increases, while 31% believe it could be done mostly with spending cuts and only 14% believe increased taxes alone would be the best policy.
While much of the wrangling we read about in the press and see on the television is real ideological difference, much is also just posturing. We know that behind the scenes the staffers who work for our elected officials are meeting and hammering out a deal. We know from anecdotal sources such as a recent article in The Hill that K Street (the lobbyists) is unhappy being shut out of the lame duck negotiating sessions. Yet for those watching this Sunday’s (Dec 2, 2012) morning shows it looks dicey. Obama wants his tax increases on those in the top bracket and it is unfortunate he is not willing to consider a higher effective rate due to the closing of deduction loopholes in return for a lower headline rate. However, if that continues to be the case and we see higher taxes for the wealthy in return for some meaningful cuts to entitlements such as those measures outlined in Boehner’s Dec 3rd letter, it might be a worthwhile compromise for long-term fiscal health. It is likely the process will be inelegant. A worst-case scenario has us going briefly over the cliff as a negotiating tactic. However, we don’t believe in a prolonged stalemate and we would see negative market reactions as a buying opportunity. So strap in and get ready it could well be a bumpy ride to the Bunny Slope.
3 Responses to “The Fiscal Bunny Slope – Whether a Patch or a Grand Bargain, there ain’t gonna be no cliff.”
The driver of the debt is Medicare costs — see this graph: http://www.ourfuture.org/files/documents/citizens… —
And the driver of Medicare costs is the medical system that costs double what other countries pay as a percent of GDP, double, with less success than the others. The Chicago Political Economy Group offers a rebuttal to this argument that makes better sense to me. The last 10 years were the worst economic 10 years since the 1930s, — in terms of GDP growth and new private sector jobs which actually was negative despite a population growth of 14.6% — and the Republican plan is a mere repeat of those 10 years. The country is 5.8% below full economic potential, about $1 trillion in missing consumption, and the suggestions here do little to address that. I believe this author would do well to read the essays at the Economic Policy Institute such as Putting America Back to Work.
Social Security is not the problem – only very moderate changes are required here, perhaps none at all if immigration policy is fixed. Medicare and Medicaid is the problem: a fee for usage system, a lack of preventive care and most important, the ridiculous rates of adult and adolescent obesity make this the key issue to be solved. It doesn't matter what you do with the health care system: if 35% of US adults are overweight or obese, then there is no fix. It is like running a pensions system where a third of the people retire at the age of 45.
Good analysis on President Obama potentially driving over the cliff in order to secure the Bush tax cut elimination, and then negotiating from that position. He risks a downgrade from the credit agencies, but short-run that won't matter too much — where else will investment go at this time? Long-run it would be a problem, but he will gamble that a bargain will be signed, which would eliminate the justification for the downgrade in the first place.
A risky strategy, but no riskier than caving in to the GOP position to try to do a bad deal before the end fo the year.
I feel you’re pessimistic not optimistic in your post, nothing is done to address or even triaged the problems. You believe D.C. will do nothing to address the deficit. ($160 billion on 1.6 trillion in new debt is like Detroit knocking down one house to fix the abandoned building problem). Your expectations based on your comments are a continued taxation of future generations to support a flawed, undisciplined, bureaucratic spending policy for the foreseeable future, in addition more debt is the solution to a debt issue. The media’s flawed policy of viewing everything through the window of a day trader is not helping anything either this problem is much longer term than the end of this calendar year. It seems that the Demarcates and Republican are trying to steal a page from Cheney and ranting about how Deficits don’t matter. I find it difficult to find a solution where GDP growths at any significant rate next year.
Government spending is taxation