News From The Fiscal Cliff

This week, the end-of-year automatic policy changes that were originally intended to steady the shaky federal budget appeared to rise in public concern.  A Wednesday front-page above-the-fold Washington Post article was headlined, “For U.S., economic worries come home / ‘Fiscal cliff’ is replacing European turmoil as top threat to recovery.”  The Congress debated (to the extent that its free-form discussion without specific legislation on the table is “debate”) the issue at length.

This sentiment was reinforced by Federal Reserve Board Chair Ben Bernanke’s twice-yearly monetary policy report to the Congress, and his associated testimony before the Senate and House banking committees on Tuesday and Wednesday (see here).  Chairman Bernanke wrote in his prepared statement that “I would like to highlight two main sources of risk:  The first is the euro-area fiscal and banking crisis; the second is the U.S. fiscal situation… As is well known, U.S. fiscal policies are on an unsustainable path, and the development of a credible medium-term plan for controlling deficits should be a high priority. At the same time, fiscal decisions should take into account the fragility of the recovery. That recovery could be endangered by the confluence of tax increases and spending reductions that will take effect early next year if no legislative action is taken.”

The Washington Post article whose title was quoted above cited a Morgan Stanley report, which said that the firm’s “Business Conditions…Index Teeters on the Edge of the Fiscal Cliff” (download the full report).  Morgan Stanley reports that 46 percent of the respondent companies for their survey “have downgraded business conditions as a result of fiscal policy uncertainty.”

Still, this assertion of adverse economic impact has been challenged.  Chad Stone (we played touch football and softball together while in graduate school, in full disclosure) of the Center on Budget and Policy Priorities, in a widely cited paper, argues that the conventional wisdom exaggerates the January 2013 impact of the “fiscal cliff” (see here).

This paper takes issue with the most common public reference, a Congressional Budget Office paper that estimates that all of the expirations, triggers and traps in the current law would drain the economy (through tax increases and spending cuts combined) of 5.1 percent of GDP between calendar years 2012 and 2013 (see here).  According to the CBO report, that enormous hit would cause what most likely would qualify as a recession.

But Stone and the CBPP argue that CBO’s scary impact number includes a full year’s worth of the effect of the policies embodied in the fiscal cliff.  Therefore, the drain on the economy in the first days or weeks after a collision with the cliff would embody only a small fraction of that.  The CBPP paper concludes from this, “Ideally, policymakers would enact such a package in the next few months… [A] debate that extends into January or early February…will not engender confidence in our political system, and the onset of tax increases and spending cuts whose duration appears uncertain will cause confusion on the part of many taxpayers, businesses, and beneficiaries of federal benefits and services… But if [policymakers] cannot reach agreement by the end of the year on a balanced plan of tax and spending changes that will improve both the mid- and long-term outlook, they should continue to work on it intensively early in the next year…[M]odest delay could produce a policy that is better for the economy over the mid- and long-term than another extension of current tax and spending policies… [and] would withdraw little aggregate demand from the economy.”

The Democratic side of the Congress appears ready to accept the CBPP argument, either implicitly or explicitly.  Senator Patty Murray (D-WA), who was a co-chair of the ill-fated Supercommittee, said in a speech on Monday (see here), “…if we can’t get a good deal—a balanced deal that calls on the wealthy to pay their fair share—then I will absolutely continue this debate into 2013, rather than lock in a long-term deal this year that throws middle class families under the bus… But… I think we have some good reasons to think a deal can happen before the end of the year.”

Senator Murray went on to reference the “no new taxes ever” pledge that the vast majority of Republican Members of Congress have signed at the behest of activitist Grover Norquist.  “On January 1st, if we haven’t gotten to a deal, Grover Norquist and his pledge are no longer relevant to this conversation… We will have a new fiscal and political reality.  If the Bush tax cuts expire, every proposal will be a tax cut proposal,  and the pledge will no longer keep Republicans boxed in and unable to compromise. If middle class families start seeing more money coming out of their paychecks next year—Are Republicans really going to stand up and fight for new tax cuts for the rich? Are they going to continue opposing the Democrats’ middle class tax cut once the slate has been wiped clean? I think they know this would be an untenable political position.”

This obviously is a political argument, but many who agree with the late Ronald Reagan that “a President should never say never” (and that the same standard should apply to Members of Congress) would have to acknowledge that Senator Murray’s argument is clever.  Senator Murray speaks appreciatively of many Republicans who privately cite the Norquist pledge as an unwise barrier to a budget solution.  For them, don’t raise taxes; allow taxes to raise themselves with the expiration of the temporary laws, and then you can cut taxes in only partial compensation, so that the increment of net additional revenues can address the deficit.  And you can redesign and improve the tax law at the same time.  Of course, Grover Norquist would argue that allowing the expiration of the temporary tax cuts is a tax increase in the terms of his pledge; however, at least in the relevant time interval between now and December 31, 2012, it is not within the power of Republicans in Congress to prevent the expiration of those temporary tax cuts.

But even though the “let ‘er rip” tactic (as it has come to be called in Washington) of driving head on into the fiscal cliff might be good politics for Democrats and others who believe that a tax increase is necessary, would it be good policy for the nation as a whole?  Or more precisely and from the macroeconomic perspective, is the CBPP analysis correct?  Would a full-speed collision with the fiscal cliff really be relatively benign, if resolved early in 2013?  Or is Morgan Stanley’s finger more accurately on the nation’s pulse?

The first and honest answer is, of course, “nobody knows for sure.”  Paraphrasing the famous dictum of the Greek philosopher Heraclitus only slightly for purposes of pertinence to our current situation, a person cannot step into the same cesspool twice.  The cesspool is changing constantly – and this particular economic cesspool arguably is larger and deeper than it ever has been within our nation’s living memory.

However, as is clear from the qualifications in the CBPP paper and (and in sections of Senator Murray’s speech that are not quoted above), there is something distinctly disquieting about the “let ‘er rip” approach.  It sends terrible signals about the workings (or lack thereof) of our government.  And beyond the atmospherics and into the pure economics, it is unclear that in the absence of congressional action the nation will cruise unaffected to January 1, 2013, and only then feel only the first partial installments of a largely delayed fiscal shock.  The actual withdrawal of the tax cuts and spending might prove to be only the final act of a larger tragedy.

Decisions by businesses and households today are based on a list of questions that they must, implicitly or explicitly, ask themselves:  What is the probability that the nation will hit the fiscal cliff?  If it does, will the policy crisis be resolved later, and if so, how long will it take?  What would be the consequences for me or my firm if any of these eventualities transpire?  What can I do in the interim to protect my interests?  And what will I need to do if and when the nation actually hits the cliff?

We could game out this contingency tree for hours, but the simplest cases probably are indicative.  A large defense contractor can calculate within some margin for error, though certainly not with precision, what the spending sequester would imply for its business.  Such a firm already would have an office with a sophisticated knowledge of the workings of Washington.  Those strategists may or may not believe that, per usual, at the last possible instant Washington will do “the right thing,” which from the firm’s perspective would be to avoid the reductions in defense spending.  If they are pessimistic on that front, the firm might conclude in prudence that they should lay off some workers to save cash ahead of the event.  However, laying off workers has a cost.  If the sequester does not occur, the firm might not be able to call the same trained, experienced workers back; those former employees might have moved on to other jobs.

So there will be inertia in that defense contractor’s decisions.  However, that inertia cuts both ways.  For the same reason why the firm will not want to fire, it also will not want to hire.  Hiring entails costs of training and assimilating, and then if the sequester does occur, those costs will yield no payoff.  So if hiring is on hold in an economy that already is weak, the uncertainty caused by the “let ‘er rip” tactic could create a downward economic spiral even before the actual event that the CBPP paper describes as relatively benign.

Still, defense contracting is only one part of the economy.  Other firms have little or no direct federal government business, and are vulnerable only to the second- or third-round effects of the spending sequester, and might not even be considering it in their near-term plans.  They would face the expiration of the tax cuts, but they might believe that the Congress would be unwilling to allow those tax cuts to expire at the end of the day.  So given the costs of actions such as laying off workers, they might be doing little or nothing other than reacting to current business conditions.  Of course, current business conditions are hardly robust, and so many forecasters worried about a potential return of recession even before the current wave of concern about Washington’s inaction on the cliff fiscal.

So what would be the net effect of “let ‘er rip?”  We truly do not know with any measure of precision.  But most economists would agree with the qualifications voiced by the CBPP and Senator Murray.  This isn’t any way to run a railroad.  We should not take chances in a weak and vulnerable economy.  And we should not take chances with the potential financial market reactions to flirting with an exploding debt.  The right course would be for the White House and the bipartisan leadership of the Congress to negotiate, promptly, an admittedly tortuous glide path through an economic recovery to budget restraint to turn our growing debt around.  But as I said months ago (see here), sound policymaking is not going to happen, either before the election or in a lame-duck session of Congress.  So we will graze the fiscal cliff, even if we do not collide with it solidly.

And one note about early 2013:  Obviously, the outcome of the election will tell us everything about the next-round outcome of the budget debate.  If divided government continues, then either our next Congress of leaders in Washington will acknowledge that they must cut the best budget deal they can with the players they then have on the field, or the consequences could be horrendous.

But one also should not assume that even a unified government will be able to snap quickly to its own pure partisan solution.  Predictions about election outcomes are no more than guesses, but accept a wild guess that the balance in the Congress will be close, even if one party wins both chambers and the White House.  Here is a hard-learned lesson:  Within narrow majorities, every minority is empowered.  Two Senators within a party with 51 votes can hijack even a reconciliation bill with the parliamentary privilege of immunity from filibuster.  Those Senators can name their price to go along.  This means that ideological extremes of either party with many more than two votes can demand a substantial toll.  Just how much discipline can a party enforce?  That remains to be seen, in the Heraclitus-equivalent in which we will find ourselves early next year.  But those who are confident that it will be easy and quick to pick up the pieces in 2013 after a collision with the fiscal cliff on December 31, 2012 may find that they have been overconfident.  Brinkmanship can yield unintended consequences.

There will be lots more to think and talk about as we approach the fiscal cliff later this year.

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