Sunday, November 4, 2012

The Fiscal Cliff: There Is No Alternative

The US is in the midst of a fiscal crisis caused by the combination of reduced revenue due to the 2008-09 recession and increased expense caused by the 2008 fiscal stimulus bill. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history (and utterly inconsistent with the AAA credit rating criteria of Moody’s and S&P).

There is no need to rehash the debate about whether President Obama or Speaker Boehner was responsible for the failure to reach a bipartisan “grand compromise” in the summer of 2011 during the debt ceiling crisis. In my opinion, Obama and Boehner were close, but both of them got too far out ahead of their House caucuses. Pelosi and Cantor each killed the deal: Pelosi, because it included Medicare reform, and Cantor, because it included a tax increase. What we got instead was the Budget Control Act of 2011. 

The BCA provided that if Congress failed to adopt the Simpson-Bowles fiscal consolidation plan, automatic expense sequestration would occur in calendar 2013. In addition, the deal to extend the Bush tax cuts was set expire in 2013. This combination of automatic cuts plus an automatic tax increase is the much-feared “fiscal cliff” that hits the US budget and economy two months from now, unless Congress decides differently.

The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. 

Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013–2021 period. By CBO’s estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO’s estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.

The Fiscal Cliff Is Necessary
In my opinion, the massive deficits of the past five years are neither moral nor prudent. The American people can be analogized to wealthy parents who, having spent all of their children’s inheritance, have also mortgaged their house and taken out a huge loan in the name of their descendants. We have spent trillions of dollars for partying on our children’s credit card. We have not only run deficits in recessions, we have run deficits during growth years. We have demonstrated a bipartisan inability to keep our fiscal house in order that keeps getting worse. This has already cost the US its AAA from S&P and will cost it Moody’s AAA as well, unless something like the fiscal cliff is allowed to occur.

I have no confidence that Congress can reach a lame-duck deal that will rein in our large and unaffordable deficits. I think that the only way to move toward fiscal discipline is to jump off the fiscal cliff in January. The CBO says that the economic impact would be a mild recession in 2013, followed by resumed growth. That strikes me as a very small price to pay for cutting the deficit in half, limiting future deficits, bringing down the debt ratio over the next decade, re-establishing the AAA ratings and laying the foundation for future prosperity.

There are aspects of the fiscal cliff that will have to be fixed, such as Medicare reimbursement, but aside from that I think that we can live with it as it is. It will ding defense and other discretionary spending, which is necessary in my view, especially given our inability to reform Medicare. And the CBO forecast includes no assumptions concerning any possible offsetting monetary stimulus from the Fed.

The following discussion of the “fiscal cliff” reflects the CBO’s latest ten-year budget outlook, published in August.

The federal budget deficit for fiscal year 2012 (ending 9.30) will total $1.1 trillion marking the fourth year in a row with a deficit of more than $1 trillion, or 7.3% of GDP.  Federal debt held by the public will reach 73% of GDP—the highest level since 1950 and about twice the 36% of GDP that it measured at the end of 2007.

The Fiscal Cliff Scenario
Substantial changes to tax and spending policies (the “fiscal cliff”) are scheduled to take effect in January 2013:
>Expiration of the Bush tax cuts;
>Sharp reductions in Medicare reimbursement rates;
>Automatic enforcement procedures (“sequestration”) to restrain discretionary and mandatory domestic and defense spending;
>Expiration of emergency unemployment benefits and of the  reduction of 2%  in the payroll tax rate

With those and other policy changes contained in the fiscal cliff, the deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4% of GDP), almost $500 billion less than the deficit in 2012.

Under the CBO’s “fiscal cliff” scenario (FCS), budget deficits are projected to continue to shrink—to 2.4% of GDP in 2014 and to 0.9% by 2022. With deficits small relative to the size of the economy, debt held by the public is projected to drop relative to GDP—from about 77%  in 2014 to about 58% in 2022 (which would be consistent with AAA bond ratings).

Most of the projected decline in the deficit occurs because revenues are set to rise considerably—from 16% of GDP in 2012 to 20% in 2014 and 21% in 2022. Between 2012 and 2014 alone, revenues in CBO’s “fiscal cliff” scenario shoot up by one-quarter as a share of GDP.

Outlays, by contrast, are projected to be a smaller share of GDP in 2022 under the FCS (22%) than they are in 2012 (23%). Discretionary spending is projected to decline relative to GDP throughout the next 10 years because of the caps on discretionary funding under the FCS. By CBO’s estimate, discretionary spending will fall to 6% of GDP by 2022—the lowest level in at least 50 years.

The Alternative Fiscal Scenario
To illustrate the consequences of possible legislative changes to the FCS, the CBO produced an alternative fiscal scenario (AFS) that incorporates the following assumptions: that all expiring tax provisions are extended indefinitely (except the payroll tax reduction in effect in calendar years 2011 and 2012); that the AMT is indexed for inflation after 2011; that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic spending reductions required by the Budget Control Act, which are set to take effect in January 2013, do not occur (although the law’s original caps on discretionary appropriations are assumed to remain in place).

That set of alternative policies (the AFS) would lead to budgetary and economic outcomes that would differ significantly, both in the near term and in later years, from those in the “fiscal cliff” scenario. In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under current law.

Under the AFS, deficits over the 2014–2022 period would be much higher than those projected under the FCS, averaging about 5% of GDP rather than 1%. Revenues would remain below 19% of GDP throughout that period, and outlays would rise to more than 24%. Debt held by the public would climb to 90% of GDP by 2022— higher than at any time since shortly after World War II.

The Economy Under The Fiscal Cliff Scenario
Under the FCS, the deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4% of GDP), almost $500 billion less than the shortfall in 2012. The CBO forecasts that such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5% between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9% in the second half of calendar year 2013.

Under the FCS, as the economy adjusts to a lower path for budget deficits, real GDP is projected to begin growing again in late 2013. The pace of economic expansion will average 4.3% from 2014 through 2017, CBO projects. As economic growth picks up, the unemployment rate is projected to decline to 8.4% in the fourth quarter of 2014 and to 5.7% by the fourth quarter of 2017.

The Economy Under The Alternative Fiscal Scenario
The AFS would lead to budgetary and economic outcomes that would differ significantly, both in the near term and in later years, from those in the FCS. In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under the FCS. The economy would be stronger in 2013: real GDP would grow by 1.7% between the fourth quarter of 2012 and the fourth quarter of 2013, and the unemployment rate would be about 8% by the end of 2013, CBO projects.

Under the AFS, real GDP would be higher in the first few years of the projection period than under the FCS, and the unemployment rate would be lower. 

However, the persistence of large budget deficits and rapidly escalating federal debt would hinder national saving and investment, thus reducing GDP and income relative to the levels that would occur with smaller deficits. The economy would grow more slowly over the 2018–2022 period than under the FCS, and interest rates would be higher. Ultimately, the CBO concludes, the AFS would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective.

So, my conclusion is that the alternative to the fiscal cliff is not a better-crafted but equally effective inflection in the debt trajectory, but rather no such inflection. The choice is thus between the fiscal cliff and ultimate ruin. Unfortunately, I expect the outcome to be much closer to the AFS than to the FCS, and ruin it will be.

No comments: