The Fiscal Cliff ‘crisis’ that the US has been deciding on since summer 2011 – but only just finding an agreement at the 13th hour on 1st January - represents a battle of ideals and policy choice that goes far beyond the normal Republican-Democrat splits.
But it is also red herring, a media induced frenzy suggesting a ‘win’ or ‘lose’ outcome on the 1stJanuary 2013 when a massive recession inducing set of policies would have come into force. But the US House of Representatives had ample time to come to an agreement on a full alternative or – as is what happened – a minor agreement to some tax rises for the wealthiest of Americans and a few other small measures, and all with the ability to retroactively apply such agreements. It is a red herring because it has made American policy for the last few months purely about this self-imposed ‘fiscal cliff’ and not about the real issue from which it is derived – the budget deficit. Theactual spending cuts and tax increases that will be needed in order to meet any kind of substantial budget deficit decrease will be massive and long term.
The cliff deal (plus expected economic growth) is forecast to begin to reduce the deficit to more acceptable levels, as a percentage of GDP at least. In 2012, deficit was approximately 7.2% of Gross Domestic Product (GDP), but with the fiscal cliff deal, this will drop to 3% by 2015. It is worth noting that much of the revenue increases seen in this more favourable balance are through projected increases in GDP as well. Note that this merely represents a reduction in borrowing. However, if GDP growth estimates are overenthusiastic, then trouble is very near at hand. The Fiscal cliff deal does not stabilise the total debt:GDP ratio.
Politically, according to Forbes, the agreement leads us to revenues in 10 years reaching about 19.4 % of GDP – at the very high end of what most Republicans say is tolerable. Spending will be at 22%, at the low end of what many Democrats think is acceptable given the aging of the population. It looks like fiscal compromise will be difficult to find.
In the meantime, the real impact of the fiscal cliff deal is that every household and every taxpayer is going to see their net pay decline in 2013. Given economic estimates of increased GDP and employment in 2014, something needs to fill the policy gap.
Budget Deficit Ceiling
The fact is that the US hit the new budget deficit ceiling already, as of January 1st 2013. The Treasury has a month or maybe two of short term measures with which it can stave off bond defaults before the financial markets will really respond to the magnitude of the issue. Now is the time that the new Congress will need to come up with a real and material solution to the budget ceiling problem.
But it is highly unlikely that the ceiling will not be raised, at least not for long. Will Congress be able to come to any agreement in the next two months?
What are the likely outcomes?
Beyond the immediate costs to the US economy, the budget ceiling will be held hostage again to deliver poor compromises on fiscal and spending policy. What will these most likely entail?
The Republicans allowed for taxation to increase on income earners above $400k and households above $450k, not agreeing to the Obama suggestion of increases above $200k and £250k respectively. They are unlikely to negotiate further on revenue from America’s wealthy. Budget forecasts now rely on increasing revenue over the next period solely through economic (GDP) growth, which is currently assumed to return to about 3% from 2014, and potential increases in tax on middle class families.
The deficit must therefore be reduced through spending cuts. At the top of the list for cuts are the ever increasing and currently unsustainable social programmes. Medicare, Obamacare subsidies, CHIP, Medicaid, Social Security currently use just under 11% GDP and are growing rapidly.
These need massive reform. This is an unsavoury outcome from the liberal point of view – it seems to be a trade off of social welfare in favour of economic growth. Republicans will be calling for spending cuts to large entitlement programs such as Medicare, Medicaid, health insurance subsidies and social security – programs which on one hand run large cash flow deficits but on the other are key to protecting low income families and the elderly.
This means that the fragile social support system in the US will be under pressure. The marginalised and vulnerable will suffer first. Then the traditional middle class tax hikes will likely follow.
And yet, economic forecasts still show ‘normal’ GDP growth returning from 2014 and unemployment coming down. To achieve this, an ideal budget agreement would have limited near-term fiscal restraint while making structural changes to gradually stabilize public debt in the longer term.
But the ultimate answer to what will happen lies with our treasured ‘free market’. This market, which is currently starting to weigh up the future of the US economy, might push investment into more rewarding markets – such as China who is actually experiencing real growth. Not only should the market move investment out of the US, but it will limit lending to the US as it becomes riskier. If it doesn’t, the US will see increasing interest payments needed to service new lending, adding to their budget deficit.
The market actions over the next few months will be the deciding factor in whether any decisions made in Congress are effective. Confidence is more important in the current economic climate than the actual policy choices; whether the US can say or do anything to promote the reality or illusion of future US growth will be seen in the next few months.
Of course, there are options to side step this discussion completely, but these are perhaps more unsavoury in the long term, and simply allow for the debt:GDP ratio to expand more and more. Obama could issue executive order to force the Treasury to increase the ceiling, but this would be highly unconstitutional. The debt limit could be abolished completely, but given the role of the US currency as the world’s reserve currency, not having a limit would be a risky strategy for global stability.
About the author: Toby Radcliffe has been an Article 13 Associate for six years. He has worked in global trade and is now a sustainability consultant at Rare Earth Consulting; he has Masters Degrees in Financial Economics, Leadership for Sustainable Development and Natural Sciences.
Toby will be regularly blogging for Article 13 on economic game changers, issues and opportunities facing us throughout 2013.
 http://www.forbes.com/sites/beltway/2013/01/03/the-bottom-line-what-the-fiscal-cliff-deal-really-means-for-taxes-and-spending/ Note that these estimatesexclude interest; they also assume that the temporary tax provisions (the so-called extenders) and the temporary Medicare physician payment adjustment expire in a year as the law states. If not, or if they are not paid for some other way, long-term revenues would be lower and spending quite a bit higher. Similarly, if the automatic spending cuts known as the sequester are repeatedly postponed and not replaced with other spending reductions, the deficit would also balloon.
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