Category Archives: Budget

The Fiscal Cliff Hangover

In itself, the so-called fiscal cliff was always a poor metaphor, as if the nation’s economy was dangerously close to a fatal dive. There were some perils, but the fundamental implication of inaction would have been for the White House to get a clean slate for 2013. I assumed, wrongly it turns out, that President Obama would intentionally fail to reach a deal with Republicans in Congress because his incentives were weighted heavily that direction. Instead, a Senate deal and a conflicted House GOP led to a last-minute agreement. The House voted in favor of the Senate deal last night. On its face, the resolution is a major Obama win, but I really think that’s all wrong.

Think about Obama’s incentives.  Polls say that Republicans would get the bulk of the blame if no deal was reached. The sunset of all the “Bush tax cuts” meant that the White House would immediately reframe the fiscal conversation as a package of Obama proposals. The DC punditry would have spent the next many, many years talking about these as “Obama tax cuts” which is not a bad brand for the Dems to build on. Third, the sequester of defense expenditures is something that many extremists on the left dearly desire, and I am not sure the President disagrees. He got none of this. Instead, he’s played his ace card: his singular identity of wanting to tax the rich more will soon be law of the land. For what? Kicking the sequester can to March 1?True, tax rates went up on the rich, but again, that ace card has now been played. It cannot be played again.

Perhaps Senator McConnell outfoxed them all. Perhaps Obama thought that  forcing Republicans to vote for tax rate increases on incomes over $400,000 per year with nary a spending cut was such good politics that it was worth locking in bad economics. The whole thing seems like a wasted opportunity to me, as it does to many others (see Bob Samuelson, Bill Gale, and  Mssrs. Bowles & Simpson).

It’s a shame that Speaker Boehner is taking such a beating from all sides because his actions, to me at least, show more leadership than almost anyone. His incentive was to get a deal done, a genuine compromise. Boehner’s Plan B, and surely his private offers as described in press reports, embodied the principles of good, wonky, bipartisan, fundamental tax reform. Deduction caps to raise revenue!  Great idea! Modifying inflation of entitlements to actually reflect real inflation and trim the growth of entitlements.  Great idea! While the President promised the poetry of “Balance,” the Speaker actually made offer after offer with equal parts revenue and spending cuts. All this goodness was spurned by the White House, to its shame.

What stinks about the final bargain is that it reveals a President unwilling to countenance even the mildest of spending restraint in the most severe crisis with the most compelling economic environment. The fiscal cliff metaphor is overrated, but the long-term fiscal crisis is not. The cost of the ATRA bill, according to the CBO, is an additional $3.6 trillion in debt over ten years. The nation sits atop a mountain of unstable debt dynamite, and every year more is added to the mountain. A trillion dollars per year, funding principally by artificially low interest rates due to monetizing by the Fed. How long can the Federal Reserve bail out the fiscal ship of state?

Maybe Obama thinks the Fed is his ultimate ace card. But when the crisis comes, when the bond market hesitates to buy new T bills with vigor, the President and the nation will be caught empty-handed.

T-Hawks versus S-Hawks

Deficit hawks are not all the same. While doves believe that deficits are necessary during recessions, and have tried to appropriate the word “growth” as their own, hawks come in two distinct types. T-hawks aim to cut fiscal deficits by raising taxes, in contrast to spending-cutters which I call S-hawks.  Alberto Alesina has a good essay making this point more elegantly in CITY Journal:

In 2011, the International Monetary Fund identified episodes from 1980 to 2005 in which 17 developed countries had aggressively reduced deficits. The IMF classified each episode as either “expenditure-based” or “tax-based,” depending on whether the government had mainly cut spending or hiked taxes. When Carlo Favero, Francesco Giavazzi, and I studied the results, it turned out that the two kinds of deficit reduction had starkly different effects: cutting spending resulted in very small, short-lived—if any—recessions, and raising taxes resulted in prolonged recessions.

We weren’t the first people to distinguish between the two kinds of deficit-cutting, of course. In the past, such critics as Paul Krugman, Christina Romer, and some economists at the IMF have responded that the two approaches don’t have different results. When an economy performs well after government spending cuts, they say, it’s actually because the business cycle has picked up, or else because the government’s monetary policy happened to be more expansionary at the time. But my colleagues and I took both factors into account in our research, carefully analyzing the business cycle and monetary policy in relation to each fiscal episode, and concluded that the difference between expenditure-based and tax-based actions remained.

… But the deficit doves are right to be wary of tax-hiking deficit reductions, as Italy, which has struggled with a high debt-to-GDP ratio for the last 20 years, demonstrates. Various Italian governments have repeatedly tried to reduce that ratio by raising more revenue, a course that has crippled the Italian economy and left the ratio firmly in place, just as the deficit doves would predict. Last November, Italy’s current government passed a very large tax hike; the country’s economy promptly nose-dived and is expected to show negative 2.6 percent growth for 2012. (Italy is finally starting to realize its errors: it has initiated a “spending review,” which should lead to spending cuts in the near future, and passed labor-market reforms.)

… My own view is that reducing the size of government is more important than protecting every dollar in the pockets of the wealthiest 1 percent. But however the resulting tax burden is distributed, the important thing is that we cut spending. Whoever wins the next presidential election in the United States will need to present a plan that changes the trajectory of the country’s debt-to-GDP ratio. It’s exceedingly important that he do it the right way.

Quick analysis: It seems the academic disagreement shows the way to political compromise.  Left academics say there is no economic difference between T and S deficit reductions. Right academics say S is better than T.  Clearly, there is room for agreement on S, so a compromise solution will be a good faith proposal by the White House to reduce spending. Will that happen?  Well, it’s the smart thing to do, but won’t happen if there are political factions that matter more than good economics.

Is the Eurozone crisis a Euro crisis?

Too many voices are pointing at the imperfections of the Euro as a monetary union, and blaming the Euro for the lingering recession across the continet, but it seems that the currency is not the root cause of problems. The real crisis is fiscal imbalance: Greek pensions, Spanish welfare, Italian debt/GDP ratio.  Contrast those nations’ fiscal policies with Germany, the Netherlands, and others.

So the question isn’t what transmission mechanism might bring the interest rate spike to U.S. bonds, it is whether the Senate can pass a budget. If America has another 5 years of trillion dollar annual budget deficits, our debt/GDP ratio surpasses Spain’s.  In fact, as AEI President Arthur Brooks recently noted in the Wall Street Journal, America is already more European than many European nations: “[O]ur debt-to-GDP ratio is 103%; Spain’s is 68%.” To be sure, if we don’t count debt America owes America, the ratio is only 73%, but CBO predicts it will rise to 200% in 25 years.