America's economy

Over the cliff?

Barack Obama must do more than avoid an economic abyss. He has a chance to fix America’s finances

Dec 15th 2012

BEN BERNANKE, the chairman of the Federal Reserve, is not known for his turns of phrase. But “fiscal cliff”—the term he coined to describe the tax increases and spending cuts that will hit America’s economy at the start of 2013 unless politicians agree to avert them—has inspired songs (“The fiscal cliff is a danger zone/It’s where grown men go when budgets are blown,” croons Merle Hazard, a satirical singer) and television comedy (Jon Stewart’sThe Daily Show” calls it “Cliffpocalypsemageddonacaust”).

There have also been more serious consequences. The shadow of the fiscal cliff has depressed corporate investment. American consumer confidence has started to wobble. Growth is slowing, perhaps to as little as 1% in the fourth quarter. Policymakers around the world are fretting: Australia’s central bank has just cut rates, citing the cliff as a worry.

The long and the short of it

If lawmakers do nothing, America faces fiscal tightening in 2013 worth up to 5% of GDP. That is a Greek-scale squeeze. It would not take many months for it to push the country into recession. A complete stand-off between Mr Obama and Congress would lead to disaster even sooner, for unless America’s lawmakers vote to increase the “debt ceiling” (the maximum amount of debt that the Treasury can issue) by around March, the federal government will be unable to pay its bills—including, potentially, its bondholders. The damage from a self-induced default would dwarf even that from the fiscal cliff.

However, precisely because the consequences of prolonged stalemate would be so disastrous, there almost certainly will not be one. Either towards the end of December, or early in 2013, Mr Obama and the Republicans in Congress are likely to reach an agreement that avoids most of the tax increases and spending cuts, and raises the debt ceiling.

Elements of that deal are becoming a little clearer: the Republicans seem to have given in to Mr Obama and accepted that wealthier Americans will have to pay more tax, probably through both limited deductions and higher tax rates.

But there are still two big reasons for America—and the rest of the world—to worry. First, depending on the details of the deal, there could still be too great a fiscal squeeze in 2013.

Second, and more important, entitlement spending is America’s biggest long-term fiscal challenge. Any fiscal deal must reform Social Security (pensions), Medicare (for the old) and Medicaid (for the poor). Mr Obama has been demanding tax increases of $1.6 trillion over the next ten years, but has offered entitlement cuts of only some $400 billion. He needs to increase the latter, to entice the Republicans into a deal and because it is the right thing to do.

America has a chance to straighten out not just its finances, but also the highly polarised politics that underpin them. Republicans believe passionately that higher taxes will wreck the economy; no Republican in Congress has voted for higher income taxes since 1990. Democrats believe equally passionately in the sanctity of health-care and pension schemes for the old. The last time pensions were overhauled was in 1983. Since then politicians have added handouts even as medical costs have soared and the population has aged. The result is a gaping, and growing, fiscal hole. America’s underlyingstructuralbudget deficit is almost 7% of GDP. Among rich countries, only Japan’s is bigger.

Since the financial crisis America’s ideological stand-off has, as it happens, produced sensible short-term fiscal policy. The United States cushioned its recession with stimulus and, by keeping fiscal policy loose, has supported the recovery. With many other rich countries tightening further and faster, that did the world a service.

In today’s weak recovery the same logic holds. With bond yields near record lows America need not, and should not, tighten policy too fast. Some tightening in 2013 is both expected and manageable. Most forecasters expect around 1.5% of GDP, as measures that were always designed to be temporary, such as the payroll-tax cut, expire. But there is a danger that a minimalist deal would result in too big a squeeze. An agreement that extended tax cuts only for the middle-class, for instance, would imply a tightening of some 3% of GDP in 2013. That is too fast.

To preserve the recovery, a deal must be less draconian. It should focus on long-term entitlement reform rather than short-term cuts. That is good politics, since overhauling entitlements is a Republican priority. And it is good economics. Spending on the old will rise faster in America than in most other rich countries. That is partly because Europe’s austerity plans have already delivered some fairly tough pension reforms, but mainly because America’s health-care costs are so high and rising fast.

A big deal

Mr Obama has the opportunity to fix this and to reform entitlements—something that has eluded every president since Ronald Reagan. The combination of his re-election and the fiscal cliff has forced the Republicans to show some flexibility on increasing the tax take. That victory has given Mr Obama leverage over the left of his own party. If he uses it to force real change, from lower indexation of pension payments to tougher means-testing of health-care benefits, he will transform America’s long-term fiscal outlook.

So far the president has shown lamentably little boldness, arguing that pensions should not be part of any deal and that health-care costs can be controlled by reducing payments to providers, such as hospitals (as opposed to cutting benefits). In private, things may be different.

Mr Obama is said to want a big deal that not only averts the fiscal cliff but sets America on a sustainable fiscal course. Such a deal is within his reach. He should grasp it.

The fiscal cliff
On the edge
What the cliff means, and why America’s deficit woes are so intractable
Dec 15th 2012

WHEN the dust from November 6th’s election settled, the re-elected Barack Obama and the re-elected Republican leaders of Congress had less than two months to avert the “fiscal cliff”, a collection of tax increases and spending cuts scheduled for the beginning of the new year. They proceeded to fritter most of it away by disparaging each other’s offers. When John Boehner, the Republican speaker of the House of Representatives, met reporters on December 7th, he moaned, “This isn’t a progress report, because there is no progress to report.”

Now, with less than three weeks to go, the pace has at last picked up. Mr Boehner and Mr Obama (pictured above) have talked twice in the past week, and representatives of both have exchanged offers. Publicly they say they are still far apart, but that is to be expected: serious negotiations seldom take place in front of cameras.
The absence of failure, at least so far, is seen by some as good news. That certainly goes for the stockmarket, which has recovered all its post-election losses. The outside world has long assumed that Mr Obama and Congress would strike a deal, because the alternative is too awful. Starting on January 2nd, taxes would jump for almost all taxpayers; a payroll-tax cut and enhanced unemployment benefits would expire; across-the-board cuts to federal spending would begin; and a clutch of other tax and spending measures would take effect. The total fiscal impact equals roughly 5% of GDP over a full year, easily enough to tip America’s economy back into recession.

To the rest of the world, the fiscal cliff seems like a freak of nature, the unintended consequence of America’s adversarial system of government. But that is too simplistic. The cliff is the product of two much deeper underlying strains. America faces an unprecedented structural gap between federal spending and federal revenue; and the political system is polarised over how that gap should be closed. Both problems have been a long time in the making, and neither is likely to go away even if a plunge over the edge is avoided.

Fiscal policy has consumed presidents since at least 1981, when Ronald Reagan slashed income-tax rates and boosted defence spending, ushering in years of deep deficits. Although the fights certainly got nasty, most important fiscal legislation in that decade was bipartisan. Large numbers in both parties voted for Mr Reagan’s original tax cuts and for the tax increases that followed; for the amendments to Social Security in 1983 that raised taxes and curbed benefits and extended the programme’s life; and for the 1986 tax-reform act that brought down personal and corporate rates and broadened the tax base by closing many loopholes. Democrats also provided support for George Bush senior’s tax increases and spending cuts in 1990.

That, however, was to be the last time Republicans agreed to higher taxes. In 1993 Bill Clinton’s deficit-reduction deal, raising taxes and cutting spending, passed with no Republican votes. Republicans did negotiate a balanced-budget pact with Mr Clinton in 1997, but only because plummeting deficits made it possible to cut capital-gains taxes along with spending.

The origins of today’s fiscal cliff lie a few years later, when George W. Bush cut tax rates on both regular income and capital gains and dividends. Democratic opposition forced Mr Bush to pass his tax cuts using a filibuster-proof Senate procedure that meant they had to expire at the end of 2010.

When Mr Obama came to office, his first big measure was a two-year stimulus plan that attracted no Republican House votes. At the end of 2010 the two sides agreed to a truce: Mr Obama extended all Mr Bush’s tax cuts to the end of 2012, and in return Republicans agreed to more stimulus, by cutting payroll taxes and extending unemployment benefits, also until the end of 2012. The next summer the two joined battle again as the Republicans threatened to let the Treasury run out of authority to borrow, risking default, without steep spending cuts. The compromise: $917 billion in spending cuts over the next decade, and $1.2 trillion more to begin, automatically, in January 2013 unless the two sides came up with a better alternative, which they failed to do.

Now what?

The clustering of so much fiscal tightening at one moment in time was thus both deliberate and perhaps inevitable, given both the political divisions and the stakes. America’s deficits have exceeded $1 trillion for four years in a row. Though the deficit has fallen from 10% of GDP in 2009 to 7% in the fiscal year that ended on September 30th (see chart on down below), that is still higher than in any year since 1946. The figure should shrink in the years ahead as the economy recovers. But if there are no changes to the current path of taxes and spending, the Congressional Budget Office reckons it will start rising again in 2019, hitting an unaffordable 7% by 2023 as the mounting cost of health care and pensions begins to swamp the budget.

Eugene Steuerle, who served in Reagan’s Treasury Department and is now a scholar at the Urban Institute, a think-tank, says the current problem is far greater than previous ones because the structure of taxes and spending is so badly distorted that there is no way to fix it without widespread pain. This, in turn, feeds the divisions between the parties, since the necessary solution would require tax increases or spending cuts on a scale that one party, or both, will find repugnant.

Mr Obama’s re-election and the Democrats’ unexpected gains in Congress have given them the upper hand in the decision, but not a free hand. The two main flash points are tax rates and entitlements.

Mr Obama originally asked for $1.6 trillion in higher revenues over the coming decade, though he is said to have dropped that to $1.4 trillion. Mr Boehner has formally offered $800 billion of higher revenue—a huge concession for a Republicanprovided it comes through limiting deductions, exemptions and other loopholes (collectively called tax expenditures), rather than raising rates. Mr Obama has all but slammed the door on that approach.

Gene Sperling, his chief economic adviser, says that it is impossible to raise anything like $1 trillion solely by closing loopholes for the rich once realistic exceptions, such as for charitable giving, are made. At most that approach yields only around $400 billion.

Mr Obama is open to tax reform, including for corporations, whose support he needs to get Republicans to negotiate. But not immediately. He would rather force Republicans to extend the middle-class tax cuts now and let rates rise on the rich as a down-payment on deficit reduction. That would provide a higherbaselinelevel of revenue that could then be reapportioned in negotiations over tax reform in 2013.

Even as some Republicans hint at conceding on tax rates, they complain that Mr Obama has yet to do the same on spending. He has offered only $400 billion of cuts, which barely scratches the main problem: the growing cost of entitlements, principally Social Security (pensions) and Medicare and Medicaid, which provide health care for the elderly and poor, respectively. Mr Obama has proposed cutting Medicare fees to hospitals, nursing homes, drug manufacturers and other health-care providers. But Medicare’s own actuaries doubt such a strategy is sustainable over the long term, because providers will lose ever more money on Medicare patients and will eventually stop accepting them.

Republicans would like to see changes to eligibility or benefits, such as less generous inflation-indexing for Social Security, higher premiums for affluent Medicare beneficiaries, and a rise in the Medicare eligibility age from 65 to 67. Mr Obama has been open to all three in the past, but Democratic resistance seems to have stiffened. Raising the Medicare eligibility ageasks the most vulnerable citizens to pay more with little to show for it in terms of long-term deficit reduction”, says Nancy Pelosi, the Democratic leader in the House.

This doesn’t mean Democrats will refuse to include cuts to benefits in the deal. But “what Democrats are prepared to give will depend on the overall amount of revenue Republicans are willing to bake in”, according to a leading Democrat.

Republicans have little leverage of their own. If the Bush tax cuts expire, Democrats will presumably simply propose to restore them in January for those earning less than $250,000, daring Republicans to block them. A recent poll by the Pew Research Centre and the Washington Post found that 53% of voters would blame Republicans if the nation toppled off the fiscal cliff, while just 27% would blame Mr Obama. Some Republicans have suggested giving up the fight on tax rates, and instead insisting on entitlement cuts as the price of raising the debt ceiling, which the Treasury is expected to hit in February or March. But Democrats consider that an empty threat; if the Republicans don’t want to be blamed for a recession-inducing rise in tax rates, they certainly do not want to be held responsible for a panic over possible default.

These dynamics all work in favour of a deal, largely on Mr Obama’s terms. But there are two big risks. The first is that it will not be big enough. Negotiators have long thought a “grand bargain” would involve cutting spending and raising taxes by $4 trillion over the coming decade, relative to what they otherwise would be. The $4 trillion amounts to roughly 2% of GDP. But when all the future obligations of the federal government are counted, Alan Auerbach, an economist the University of California at Berkeley, reckons it would actually take higher taxes and reduced spending worth 8.4% of GDP to stabilise the debt at its current share of GDP. The reason is that America’s real fiscal problems relate not to the current deficit, which mostly derives from the weakness of the economy, but from the growth of entitlements over future decades. Republicans have been more serious about addressing that problem, but neither party has a credible proposal on the table.

The other big problem is political. On a variety of measures, the election left America more polarised than ever.

Bill Galston of the Brookings Institution notes Mr Obama’s victory margin this year was half what it was in 2008, but the number of states that were decided narrowly—by five percentage points or less—actually shrank, to four from six. That means more states are voting heavily for one candidate or another. “States are dispersing away from the mean, towards the redder and bluer ends of the continuum,” he says. Most members of the House are in safe seats, so they do not have to worry about what the country as a whole wants if their constituents disagree. Supporters of Mitt Romney picked out the deficit as their priority, according to a poll by the National Journal and Allstate, an insurance company. For Mr Obama’s supporters, it came only fifth, behind education, jobs, health-care costs and entitlement programmes.

Polarisation makes it harder to strike a deal, and harder to make any deal stick since the other side will try to undo it after the next election. Republican candidates for the presidential nomination of 2016 may well feel obliged to repudiate any tax increase that is agreed on now.

On the other hand, both Mr Obama and Mr Boehner know their legacies depend on finding a lasting solution to the deficit problem. If the current negotiations do succeed in turning America’s fiscal tide, history will conclude that the fiscal cliff made it possible. But don’t expect anyone to be grateful.

The Euroless Union?

Barry Eichengreen

13 December 2012


BERKELEY – Europe’s crisis has entered a quiet phase, which is no accident. The current period of relative calm coincides with the approach of Germany’s federal election in 2013, in which the incumbent chancellor, Angela Merkel, will be running as the woman who saved the euro.

But the crisis will be back, if not before Germany’s upcoming election, then after. Southern Europe has not done enough to enhance its competitiveness, while northern Europe has not done enough to boost demand. Debt burdens remain crushing, and Europe’s economy remains unable to grow.
Across the continent, political divisions are deepening. For all of these reasons, the specter of a eurozone collapse has not been dispatched.

 The consequences of a collapse would not be pretty. Whichever country precipitated itGermany by threatening to abandon the euro, or Greece or Spain by actually doing so – would trigger economic chaos and incur its neighbors’ wrath. To protect themselves from the financial fallout, governments would invoke obscure clauses in EU treaties in order to slap temporary controls on capital flows and ring-fence their banking systems. They would close their borders to stem capital flight. It would be each country for itself.

Would the European Union survive? The answer depends on what one means by the EU. If one means its political organs – the European Commission, the European Parliament, and the European Court of Justice, then the answer is yes. These institutions are now a half-century old; they are not going away.

As for the single market, the EU’s landmark achievement, there is no question that a eurozone breakup would severely disrupt its operation in the short run. Trucks would be halted at national borders. Banking and financial systems would be balkanized. Workers would be prevented from moving.
But what would happen then? There has always been a debate about whether it is possible to have a single market without a single currency. Critics of the euro have always asked: Why not?

Under this scenario, the Single European Act, signed in 1986, would remain in place. Member states would be obliged to restore free movement of goods, capital, services, and people – the EU’s four freedoms” – as quickly as possible. Given the clear benefits that Europe has derived from the single market, they would have every incentive to do so.

Proponents of the single currency object that if Europe has separate national currencies, it will have separate banking systems, each with its own lender of last resort. So much, then, for a single market in financial services, or for harmonizing regulation and removing trade barriers behind the border. Free trade in goods and free movement of capital and labor would not survive the euro’s collapse, these diehard Europhiles warn. We may yet find out if they are right.

And what about the acquis communautaire, the body of law that enshrines member states’ obligations not just in terms of economic policies, but also in terms of democracy, the rule of law, and fundamental human rights? The intent of the acquis is not simply to make Europe more prosperous, but to make it more civilized. Spain, Portugal, and Greece had to establish functioning democracies before applying for EU membership. Even now, Hungary and Romania feel peer pressure and face sanctions from their EU partners when they engage in dubious electoral practices, compromise their courts’ independence, or discriminate against minorities.

 The cooperation needed to make that peer pressure effective might conceivably survive the euro’s collapse. But finger-pointing about which country was responsible for Europe’s damaging financial disruption would make it difficult for the members to maintain a common front. It seems likely that the acquis would lose much of its force.

 A final way of thinking about the EU is as the “ever closer unionreferred to in the Treaty of Rome and echoed in the Maastricht Treaty. Ever closer unionmeans an EU that moves ineluctably from economic and monetary union to banking union, then to fiscal union, and finally to political union.

This is what European leaders had in mind when they created the euro. They hoped that establishing a monetary union would generate irresistible pressure for the creation of an EU that functioned in all respects as a cohesive economic and political bloc.

Europe’s leaders were right about the pressure. Monetary union without banking union will not work, and a workable banking union requires at least some elements of fiscal and political union. But they were wrong about the irresistible part. There is no inevitability about what comes next.

Europe can either move forward, toward deeper integration, or it can move backward, toward national sovereignty. Its leaders and, this time, its people need to decide. It is on their decision alone that the future of both the euro and the EU depends. 

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.