Going Over the Cliff!

Going over the fiscal cliff?

Warnings are everywhere that we must avoid the fiscal cliff or else face recession.    The fiscal cliff is a series of tax hikes and spending cuts resulting from an inability to achieve targets on deficit reduction set in 2011.   The spending cuts hit 1000 government programs, touching ones dear to both Republicans (military spending) and Democrats (Medicare).

Most of the cliff involves repeal of the payroll tax cut (which expires in December) and the Bush tax cuts (which expire January 1).   The argument is that the mix of tax increases and spending cuts will seriously damage the economy and cause growth rates to plummet into recessionary territory.

The impact of the “cliff”

All this is set up by the negotiations around the debt ceiling back in 2011.   The Republicans refused to raise the debt ceiling unless budget cuts were made to halt the increase in the deficit.    President Obama entered into negotiations with House Speaker John Boehner to try to reach a grand bargain to do just that.   The talks failed.  The “grand bargain” that the Republicans walked away from would have been about 85% spending cuts and 15% tax increases.

Republicans rejected any tax increase, making a deal all but impossible to reach.   236 of the 242 House Republicans, and 40 of the 47 Republican Senators have signed a pledge to Grover Norquist’s “Americans for Tax Reform” organization promising not to raise taxes ever.    Many Republicans figured that if they held out they could take the Presidency and Senate in 2012  and then craft their own measure with no need to compromise or raise taxes.

At the time people thought the Republicans had bested the President.   He was ridiculed by progressives as having been naive, willing to bargain with Republicans when their goal was to do whatever they could to defeat him in 2012.   He was called spineless for not invoking the 14th amendment to circumvent Congress and raise the debt ceiling unilaterally.  Obama’s lowest ratings were in the wake of the breakdown of those talks.   In retrospect Obama looks like a strategic genius – the Democrats have set up a situation where they hold the best cards, thanks to the sequestration deal and the automatic expiration of the Bush tax cuts.

So will the fiscal cliff cause a recession?   Perhaps, but the damage will be limited.  A couple charts:

Note how quickly the economy recovers after the sharp dip

And:

Note that the damage is mostly in Q1 2013, cliff or no cliff the prognoses for the rest of 2013 are similar

Beyond that, growth after 2013 is robust, even if we go over the cliff:

By 2014, things could be improving dramatically

Going over the cliff could enforce a kind of restraint that would yield long term benefits.  At the very least it would unclog the gridlock preventing real solutions to the budgetary and economic crises.   Letting the Bush tax cuts expire would render the pledge to Norquist meaningless — taxes would go up automatically and any agreement to cut taxes to the middle class would be a tax cut, not a tax increase.

So why all the alarm?

Besides the fact that the slow down in 2013 would be real, there is concern about the cuts themselves.   Many important government programs will be cut, angering the left.   Defense spending will be cut, angering the right.   Good!  This will force them into meaningful negotiations.

The Republicans essentially demanded no tax increases or defense cuts, but steep cuts to entitlements, social welfare programs, education and programs Republicans disliked (such as PBS).   In the heady days after the 2010 election that might have seemed feasible, especially if they were going to win back the Presidency and Senate.   Now it’s a pipe dream.

President Obama was re-elected, the Democrats remarkably gained two Senate seats and even though the Republicans still hold the House, the majority is smaller and overall Democratic candidates for the House received more votes than did the Republicans.    The Democrats have every incentive to make a deal now, while the Republicans would prefer to come up with a piecemeal deal to push the issue down the road to when political conditions are more favorable.   The farther they can get from the 2012 election the better it will be for them.

If we go off the fiscal cliff, the GOP will be forced to deal quickly.  To prevent tax increases on the middle class there may be a will to increase capital gains taxes – something that could raise significant money.   Those low tax rates are why Warren Buffet pays a lower rate than his Secretary and why Governor Romney  thought it more harmful to release his tax returns than to keep them secret.

Nothing should be off the table.    Each side could recover from political hits by the 2014 election, better to act sooner rather than later.   Going over the cliff will make both sides eager to reach a deal.

Expected tax increases should we go off “the fiscal cliff”

The danger in that is that the Democrats could make the mistake the Republicans did and overplay their hand.    In 2014 it is unlikely the Democrats will gain the House, and if this deal goes bad due to Democratic intransigence the Republicans could have another big off year election.    The Republicans blew it by not making a deal when they were in a position of strength, the Democrats can’t afford to make the same mistake.

It could be that the cliff is the only thing that will force both sides to actually make structural reforms that can lead to a sustainable budget.     It’s not just about the money.   The Democrats can “give” on issues like taxes and defense in part in exchange for tougher regulations on Wall Street and less resistance on appointments to agencies like the FHFA (Federal Housing Finance Agency).

Perhaps the Monster has a good heart?

Ultimately we all lose if there isn’t bold action as quickly as possible to get the government to a sustainable budget with a modicum of bipartisan support.    Fear of the cliff stands in the way of making bold choices and creates the danger of kicking the can down the road to deal with at a later date.   Go off the cliff.   Face reality.   A sharp down turn will be short and followed by growth.   The pain will be limited, and it just might force the politicians to make difficult choices.

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  1. #1 by Titfortat on November 26, 2012 - 23:00

    This post reminds me of the quote.

    “Pain is inevitable, suffering is optional”

  2. #2 by lbwoodgate on November 27, 2012 - 04:54

    I’m still not convinced that what little taxes that increases the low and middle income earnings will seriously alter purchasing habits. Most of what they spend their money are essentials anyway. Higher income earners are faced with college expenses and upgrading cars and homes but as your charts point out, this will likely only be temporary. The tax revenue goes toward paying down the debt and this appeals to investors at home and abroad. Job creation is still critical to get the economy going again so spending should be limited until we achieve this, at least until we reach traditional low unemployment levels at or below 5% again.

    Most of the hype based on what I read from economists Dean Baker and Paul Krugman is to scare enough people to convince them we need to gut the social safety net programs. Social Security doesn’t need to be cut because it is self-sustaing and doesn’t take one cent from the debt and the fat we need to trim from Medicare should not be from the paltry benefits of recipients but from the exorbitant costs charged by many health care providers and medical suppliers.

  3. #3 by GiRRL_Earth on November 27, 2012 - 08:52

    Great post Scott!

  4. #4 by dirtnrocksnomo on November 30, 2012 - 16:21

    Democrats almost have to go over the “cliff” just to prove they’ve grown a spine. Obama is holding all the cards going into this. I trust he’ll play republicans like a fiddle just as he has since his inaguration.

  5. #5 by bruce on December 2, 2012 - 18:19

    The pie chart is fascinating. The ending of the payroll tax holiday is supported across the board I think, and it is the bulk of the so called cliff.

  6. #6 by brucetheeconomist on December 5, 2012 - 01:29

    I misread the chart I think. My mistake.

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