Anatomy of the US fiscal cliff

November 11, 2012 3:02 pm

by Gavyn Davies


The re-election of President Obama last Tuesday has triggered a fairly sharp fall in US equity prices, along with a decline in bond yields. Although I argued in this blog last weekend that bonds would prefer an Obama win, while equities would prefer a Romney victory, the extent of the decline in equities in mid week came as a surprise. To some extent, the market was reacting to prospective increases in capital gains taxes, and to tighter regulation of the financial sector, in the President’s second term. But undoubtedly the main factor was uncertainty about the fiscal cliff.

Most investors are assuming that Washington will agree to postpone most of the fiscal tightening which is implied by the “cliff”, but only after prolonged negotiations which could continue past the initial deadline at the year end, when the lame duck Congress departs from the Hill, and which might even be extended past the President’s inauguration on 21 January.

The standard assumption is that the outcome will involve a fiscal tightening of 1 per cent of GDP next year, which is enough to keep GDP growth well below trend, but not enough to cause a recession. But there are many other possible outcomes which are likely to keep investors very nervous until this is finally settled.

The “cliff consists of a series of tax and expenditure measures which have already been legislated to take effect on 1 January 2013, and which taken together would tighten fiscal policy by $502 billion in 2013, and $682 billion in 2014 (3.9 per cent of GDP). Legislation has to be amended if this is not going to take place, which is why both parties have the ability to block progress. Unless the House Republicans agree on a compromise with the Senate Democrats, and the President, this fiscal package will be automatically triggered.

Furthermore, the federal debt ceiling needs to be increased in the next couple of months, which also gives the House Republicans the kind of blocking power they used in July 2011.

There are five main elements in the composition of the cliff. To simplify information which has recently been published by the Congressional Budget Office, they are the following:


Focusing on the 2014 figures, cuts in defence (item 1), medicare and other government spending (item 2) amount to $112 billion, or 16 per cent of the overall tightening.

The ending of the Bush tax cuts on lower and middle income groups (item 3) accounts for $382 billion, or 56 per cent of the total. The Bush tax cuts for upper income groups, which is by far the most politically contentious area, amounts to only $38 billion, or 6 per cent of the total. That leaves $150 billion (22 per cent of the total) coming from the ending of the payroll tax cuts, and the emergency unemployment benefits which were agreed in 2010.

The CBO has also estimated the economic impact of each of the separate components of the cliff. This is what the results look like:

The overall impact on US GDP next year, if the entire cliff were to take effect, would be to reduce real GDP by 2.9 per cent, and reduce employment by 3.4 million jobs. No wonder the markets are worried.

However, while both parties agree that a large fiscal tightening will be needed in the long term to ensure sustainability in the public accounts, it does not appear that either party wants to implement all of this tightening in 2013. The argument is over which part should go ahead, and which part should be postponed. By far the most difficult bone of contention is the smallest item, the Bush tax cuts for the upper income groups. Ironically, the CBO figures imply that this item would have almost no immediate impact on the economy.

The House Republicans have repeatedly argued that there should be no increase in marginal tax rates, though the Speaker John Boehner appeared last week to suggest that some other form of revenue increase might be acceptable to him. The President, in contrast, believes that he has a decisive electoral mandate for tax increases on upper income families, and does not see why he should lose this debate. He is being encouraged in this by many of his political allies. A possible compromise could be to apply higher tax rates on families with annual income of (say) $ 1 million a year, rather than the $250,000 a year which the President discussed in the election campaign.

Other items might be much easier to agree upon. Both sides seem ready to accept that this is not the right time to increase taxes on lower and middle income groups, so the elimination of item 3 seems probable. On the other hand, there seems relatively little support for extending the reliefs in item 5, so this area of tightening may well survive. Finally, some part of the tightening in items 1 and 2 might be necessary to placate the House Republicans, who are eager for spending cuts.

This would produce an overall fiscal tightening of about $200 billion, which is the 1 per cent of GDP assumed by the markets. On top of that, there may be more fiscal tightening in the pipeline, stemming from reductions in spending by state and local authorities. J.P. Morgan economists said this week that this may result in an overall fiscal tightening of around 2 per cent of GDP in 2013, which is more than the market expects.

Finally, what would all this do to the longer term outlook for US public debt? If the fiscal cliff is allowed to take full effect on 1 January, then the path for federal debt held by the public would follow the CBObaseline policyshown in the chart below:

Under this baseline (blue line), the debt ratio would peak at 76.6 per cent of GDP in 2014, and then decline to 58.5 per cent in 2022. The US debt crisis would, in effect, be over, though the economy would probably fall into recession in 2013.

At the other extreme, if almost all of the cliff were postponed indefinitely, then the debt ratio would continue to rise rapidly, reaching 90 per cent by 2022 (red line). Something in between these two extremes appears to be needed.

If the compromise plan outlined above were implemented for two years, followed by full implementation of the cliff when the economy is assumed to have recovered in 2015, then the debt ratio would follow the green line. This seems like a sensible compromise between the need to boost the economy in the near term, and the imperative to control debt in the longer term.

The markets would like it, even though there would be legitimate doubts about whether the American political system would actually be able to impose the fiscal tightening when 2015 comes around.

Can Washington agree to such a compromise? Probably, but only after a lot of political wrangling first.

The real winner: Inflation

November 9, 2012 @ 7:19 pm

By Matthew Stevenson

PHOTO: William Jennings Bryan, celebrated for his “Cross of Gold” speech, standing on stage to deliver a campaign speech. LIBRARY OF CONGRESS

I buy none of the post-election, prime-time hokum that what decided the presidential race was the Latino vote, women’s issues, the next Supreme Court justices, the view from the fiscal cliff or how drones are winning the War on Terror. This presidential election was, as always, a contest between gold standardists and inflationists.

The victors were the forces of cheap money. William Jennings Bryan would be proud ‑ as would bimetalists and Weimar Republicans.

Inflation won because it is the panacea for all that ails the body politic: a short-term cure-all that promises economic growth, the possibility of paying off runaway national and international debts, new-found prosperity for the middle classes and liquidity for the impoverished, who otherwise would be voting in the streets with rocks and burning tires.

Think of it as doping for those wanting to win political races.

Cheap money defers many liabilities. Real wages for industrials workers have declined since the 1970s. True unemployment ‑ including those too discouraged to look further and others working part-time for unlivable wages ‑ is closer to 22 percent than the official figure of 7.9 percent. The national debt, $16.3 trillion, exceeds the gross national product. With unfunded entitlement programs, such as Medicare and Social Security, the government is eventually on the hook for an additional $46 trillion, which it would rather not pay with pieces of eight.

The hard-money men have not been able to win many elections since the 19th century, arguing as they do for reductions in the monetary supply; an asset-backed currency (preferably with gold) and policies that lead to deflation. These are a boon to lending institutions that want to get repaid with readily convertible cash, not watered stock.

The magic of inflation, before it turns everything to dust, is that it papers over a number of intractable financial problems. The United States is now able to run monumental trade and budget deficits, fight multiple foreign wars, vote tax cuts, extend unfunded pension and healthcare benefits to citizens over age 65 and spend money with Medici-like munificence on myriad federal programs by printing money or borrowing in national and international capital markets.

Were the dollar unacceptable as a reserve currency in investor portfolios here and abroad, these financial sleights of hand would have ended long ago. Imagine the consequences if the Chinese demanded gold, diamonds or barrels of oil as collateral for their U.S. dollar bond investments. Already, the dollar is badly depreciated against many currencies, including the Swiss franc and the euro.

The reason lenders to the American dream don’t demand hard assets in exchange for their full faith and credit is that most marketplace debt, as well as the circulating currency, comes with the guarantee of the U.S. federal government ‑ perhaps why a pyramid is printed on the back of a dollar bill.

Think about it: Bank deposits, mortgages, the balance sheets of large banks and hedge funds, Social Security, Medicare, defense spending and General Motors all fall under the rubric of beingtoo big to fail.” They have the implicit aval (endorsement) of the federal government, which pays its obligations with inflated money ‑ as opposed to doubloons carried around in a sack.

Why, then, does the economic data never show inflation as a problem, one that might have become a discussion point in the election? Since 2000, the consumer price index has shown inflation hovering between a manageable 2 percent and 4 percent per year.

The reason the inflation statistics alarm few is because it is far easier to manipulate economic data than it is to control runaway inflation, which ought to be synonymous with four-year college tuition at $200,000, one-bedroom apartments in New York City priced at $1 million, gasoline at $3.46 a gallon and carts of groceries that routinely cost at least $250. Nonetheless, the September consumer price index showed inflation at a modest 2 percent per year.

Another reason inflation enjoys such electoral pull is that it allows the political classes to maintain the illusion of power and authority. Without the ability to print and circulate paper money to balance the books on $16 trillion in national debt and $1.4 trillion in budget deficits, U.S. presidents would be riding Greyhound on their appointed rounds, not the magic carpet of Air Force One.

Click to enlarge

Inflation carries the swing states of the American imagination because the tenets of a democracy are not consistent with deflationary politics, which favor landed and moneyed interests. In the 19th century, when deflation had its halcyon days, the winners were the railroad trusts, J.P. Morgan and John D. Rockefeller, all of whom demanded gold-based assets in settlement of obligations due in their favor.

The reason inflation finds so many willing partners is that, initially, it seems a painless way to pay off thorny debts; raise the illusions of prosperity (“Wow, I got a raise”) and provide society with a veneer of fairness. Nonetheless, inflation is best understood as a direct tax on the savings of American citizens, especially those of the middle classes, who lack hedges against its effectslarge real estate portfolios, say, or vaults of gold.

What stops the inflation Ferris wheel is when the currency is reduced to worthlessness. During the worst of Weimar’s inflation in the 1920s, robbers would steal suitcases of money and throw away the cash before fleeing.

In the case of the United States, the economic carnival will end when the dollar is no longer acceptable as a reserve currency, first in international markets and later domestically.

Part of the reason that a barrel of oil costs $85, not $10, in world markets is because traders discount the value of the dollars that they will receive when accepting payments. The only reason the Chinese hold debts denominated in dollars is because it helps them maintain the artificially low exchange rate of the renminbi.

Whether or not the United States goes over the fiscal cliff, it will remain unified as a nation of debtors for whom the goal is always to repay their loans with debased currency.

Adam Ferguson, in the introduction to his book, “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany,” writes: “This is, I believe, a moral tale. It goes far to prove the revolutionary axiom that if you wish to destroy a nation you must first corrupt its currency. Thus must sound money be the first bastion of a society’s defense.”

No wonder Adolf Hitler, when he led a beer hall putsch in 1923, spoke of addressing “the revolt of starving billionaires.” For that kind of money, he could have also paid for a political campaign.

Matthew Stevenson, a contributing editor at Harper’s Magazine, is the author of “Remembering the Twentieth Century Limited,” a collection of historical travel essays. His next book is “Whistle-Stopping America.”

A Man Without a Plan

Robert J. Shiller

11 November 2012


NEW HAVENDuring the United States’ recent presidential election campaign, public-opinion polls consistently showed that the economy – and especially unemployment – was voters’ number one concern. The Republican challenger, Mitt Romney, sought to capitalize on the issue, asserting: “The president’s plans haven’t worked – he doesn’t have a plan to get the economy going.”

Nonetheless, Barack Obama was reelected. The outcome may reflect the economy’s slight improvement at election time (as happened when Franklin Roosevelt defeated the Republican Alf Landon in 1936, despite the continuing Great Depression). But Obama’s victory might also be a testament to most US voters’ basic sense of economic reality.
Economic theory does not provide an unambiguous prescription for policymakers. Professional opinion in macroeconomics is, as always, in disarray. Because controlled experiments to test policy prescriptions are impossible, we will never have a definitive test of macroeconomic measures.
Romney had no miracle cure, either, but he attempted to tap into voters’ wishful-thinking bias, by promising to reduce the size of the government and cut marginal tax rates. That would work if it were true that the best way to ensure economic recovery were to leave more money on the table for individuals. But the electorate did not succumb to wishful thinking.
The idea that Obama lacks a plan is right in a sense: nothing he has proposed has been big enough to boost the US economy’s painfully slow recovery from the 2007-9 recession, nor to insulate it from shocks coming from Europe and from weakening growth in the rest of the world.

What Obama does have is a history of bringing in capable economic advisers. Is there anything more, really, that one can ask of a president?
And yet US presidential campaigns generally neglect discussion of advisers or intellectual influences. Although a president’s advisers may change, one would think that candidates would acknowledge them, if only to suggest where their own ideas come from; after all, realistically what they are selling is their ability to judge and manage expertise, not their own ability as economists. This time, too, however, there was no mention by name of any deep economic thinker, or of any specific economic model.
Obama originally had a wonder team of economic advisers, including Lawrence Summers, Christina Romer, Austan Goolsbee, and Cass Sunstein. But they are gone now.
Today, the most powerful economic adviser remaining in the White House is Gene Sperling, head of the National Economic Council (NEC), the agency created by President Bill Clinton in 1993 to serve as his main source of economic policy (somewhat shunting aside the Council of Economic Advisers). Because this position does not require Congressional approval, the president may appoint whomever he wants, without having his choice raked over the coals in the US Senate. That is why Obama could appoint the highly talented but politically unpopular Summers, the former president of Harvard University.
Sperling is not nearly so well known as Summers. But his record of influence in government is striking; indeed, he has been at the pinnacle of economic-policymaking power in the US for almost a decade. He was the NEC’s deputy director from its beginning in 1993 until 1996, and its director from 1996 to 2000. Obama reappointed him as head of the NEC in January 2011.
His 2005 book The Pro-Growth Progressive contains many ideas about how to make the economy perform better. None is grandiose, but together they might help substantially. Some of these ideas found their way into the American Jobs Act, which might have had some real impact had Congress passed it in 2011.
The AJA embodied some of what Sperling describes in his book: subsidies for hiring, wage insurance, and job training, as well as support for education and early learning. Moreover, the AJA would have offered some balanced-budget stimulus – the kind of stimulus that would boost the level of economic activity without increasing the volume of government debt.
But the public, despite its concern about unemployment, is not very interested in the details of concrete plans to create more jobs. Sperling is just not very visible to the public. His book was not a best seller: in commercial terms, it might be better described as a dud.
Sperling is fundamentally different from the typical academic economist, who tends to concentrate on advancing economic theory and statistics. He concentrates on legislation – that is, practical things that might be accomplished to lift the economy. He listens to academic economists, but is focused differently.
At one point in his book, Sperling jokes that maybe the US needs a third political party, called the “Humility Party.” Its members would admit that there are no miraculous solutions to America’s economic problems, and they would focus on the “practical options” that are actually available to make things a little better.
In fact, Americans do not need a new political party: with Obama’s reelection, voters have endorsed precisely that credo of pragmatic idealism.
Robert J. Shiller is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, the second edition of which predicted the coming collapse of the real-estate bubble, and, most recently, Finance and the Good Society.

Copyright Project Syndicate -