By
Christopher Mahoney
:
The U.S. 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
Barack Obama or Speaker John 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. Representatives Nancy Pelosi and Eric 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 to expire in 2013. This
combination of automatic cuts plus an automatic tax increase is the
much-feared "fiscal cliff" that hits the U.S. 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 non-defense 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 non-defense 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 are analogous t o
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 U.S. 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, m arking 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:
-
Exp iration of the Bush tax cuts;
-
Sharp reductions in Medicare reimbursement rates;
-
Auto matic enforcement procedures ("sequestration") to
restrain discretionary and mandatory domestic and defense
spending;
-
Expir ation 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 - fro m 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 - th e 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)) t
hat incorporates the following assumptions: T hat 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.
Conclusion
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.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
See also
Deutsche Bank: Explaining The $12 Billion Loss That
Never Was
on seekingalpha.com