Posted on November 20, 2012

Fiscal Debate Redux

We can all hearken back to the bad old days of August 2011, the last debt-ceiling trauma, when the Teapartyers threatened to shut down the government and risk default. Indeed, the fiscal cliff sequester of discretionary government spending, which cuts mainly defense by about $78 billion in 2013, emanates from that debacle.

It was the price to be paid for the Super Committee’s failure to come to a budget compromise. The public was so fed up with the dysfunction on Capitol Hill that the approval rating for Congress fell to an astonishingly low 10%. Congressman Paul Ryan was on the Super Committee. As well, in 2010, he was on the Simpson-Bowles Commission where he voted against the report, helping to derail it. The 18-member panel needed 14 votes to send a 10-year plan to trim the debt to Congress for a vote.

As his party’s then-ranking member on the House Budget Committee, Ryan led a bloc of three House Republicans who denied the additional votes needed. All three Senate Republicans on the panel backed the plan, accusing the House Republicans of being “disproportionately affected by the anti-tax lobbyist, Grover Norquist, on the issue of tax reform,”(said Republican Senator Judd Gregg (NH), according to Bloomberg Businessweek). Senate Republicans are stepping away from the Norquist Anti-Tax Pledge in coming to a resolution of the fiscal cliff; but, to date, no House Republican has done so.

Odd, given that they all must face the voters in two years and would surely not want to have the blood of an austerity recession on their hands. Equally culpable are Democrats who refuse to consider entitlement spending cuts. It is early days yet. The Congress is a body that functions best under pressure. I expect an eleventh-hour accord in mid-to-late-December as the Christmas recess might well be breached. But this deal will be a stopgap measure and necessarily so. It will do nothing to alleviate the longer-term debt-reduction issue and too much austerity near term could be terrible for the economy. So much so that the Fed is pondering further measures to increase monetary stimulus. Chicago Fed President Charles Evans said in Toronto this week that he has revised downward his proposed unemployment target and inflation ceiling. He and other members of the policymaking FOMC are pushing for the Fed to stipulate publically that they will continue to keep interest rates extremely low and continue open-ended quantitative easing until the jobless rate falls below 6.5% (formerly 7%) and nonfarm payrolls grow by 200,000 per month for a sustained period unless the core PCE inflation forecast rises above 2.5% (formerly 3%).

He is well aware that a consensus forecast for inflation might be difficult to achieve, but feels the Committee is sufficiently cohesive to follow this approach. The need for such unprecedented Fed policy is, according to Evans, largely the result of the fiscal austerity crisis. He presumes that a meaningful deficit-reduction package will be forthcoming. In the meantime, businesses and markets are wary of the negative economic impact of tax increases and spending cuts and, perhaps most of all, the uncertainty associated with the coming deliberations that will stretch into next year, potentially peaking in the first few months of 2013. If the Congress can come to a big fiscal deal before then, the debt ceiling will have been raised along the way. Ironically, if no deal is reached on the fiscal cliff, the deficit problem is solved before hitting the debt ceiling because the scheduled tax increases and spending cuts would reduce the ten-year deficits by over $6.8 trillion relative to current policy projections. This would be enough to put the debt-to-GDP ratio on a sharp downward trajectory that would be extremely disruptive, according to the Committee for Responsible Federal Budget. The Congressional Budget Office (CBO) agrees that public debt would fall from 75.8% of GDP in 2013 to 61.3% in 2022 in the no-deal scenario. In those circumstances, the Republicans would be impelled to raise the debt limit.

However, the economy could well be pushed into recession, tax rates would rise for the middle class and government program spending would be slashed. Hopefully, this won’t happen as cooler heads prevail. The media continues to report little progress, but comments from Washington are conflicting. House Speaker John Boehner, the top Republican in Congress, dashed hopes that lawmakers were getting closer to a budget deal, but the U.S. stock market continued to eke out gains all week. There have been some signs that leaders are moving closer to a fiscal agreement.

Bottom Line: This will drag on for several weeks yet, but a calamity is likely to be averted. By the time the debt ceiling becomes binding again in February of next year, Washington will have come to an agreement on longer-term debt reduction. If they do a good job, neither party will like it.