With President Obama’s re-election, the countdown begins for lawmakers to address the 2013 fiscal cliff and the Treasury’s statutory debt limit. But unless the President and House Republicans agree to change the current law, these crises cannot be resolved.
It’s been just three weeks since US President Barack Obama won the re-election, but a doubt whether he can forge a productive second term in a divided political system has already started doing the rounds across political arenas. No doubt, the Presidency is settled, but little else is. Policy uncertainty has been one of the biggest obstacles to Uncle Sam’s economic growth over the past few years, and the outcome of the recent Presidential election is unlikely to change much. The scenario could become even worse as Washington’s fiscal debate intensifies. Reason: President Obama has two big decisions to make and that too by early 2013.
The first is what to do about the so-called fiscal cliff – the substantial tax increases and government spending cuts scheduled to hit next year under current law. The second is how to achieve fiscal sustainability; that is, what long-term tax and spending changes will make future budget deficits small enough so that the nation’s debt-to-GDP ratio (103% of US GDP) stabilises. What Obama decides today will determine how the US economy performs tomorrow.
The fiscal cliff describes what will happen if the Bush-era tax cuts, this year’s payroll-tax holiday, and the emergency unemployment insurance programme all expire on schedule, just as government spending drops according to the terms of last summer’s deal to raise the Treasury debt ceiling. Those would be on top of several temporary tax and spending adjustments that Congress normally extends each year, affecting the Alternative Minimum Tax (the so-called “AMT patch”) and Medicare’s reimbursement schedule for doctors (known as the “Medicare doc fix”). If policymakers do nothing before the end 2012, the resulting tax increases and spending cuts will total $715 billion in 2013, equal to about 4.3% of GDP.
Fiscal sustainability is attained when a country’s debt grows in tandem with its GDP. The Great Recession, by contrast, resulted in a near doubling of the US debt-to-GDP ratio over the past five years. If the fiscal policy remains unchanged, the debt load will continue to outpace growth, eventually triggering an economic crisis. Under reasonable economic assumptions, Obama needs to reduce the annual budget deficits by $3 trillion over the next decade to attain fiscal sustainability. This amount includes the $1 trillion in spending cuts agreed to as part of last summer’s increase in the Treasury debt ceiling, but not the $1 trillion in automatic spending cuts, known as sequestration, that also were part of that deal. If Obama makes these necessary changes, deficits by 2020 will equal no more than 3% of GDP. Given the expected pace of GDP growth, that will stabilise the debt-to-GDP ratio.
Going by this logic, the solution to Uncle Sam’s problem seems to be simple. Obama should decide to do nothing, stick to current law, and let the nation go over the fiscal cliff. This would solve the fiscal sustainability problem: Higher tax revenues and lower spending would make future budget deficits small enough to bring the debt-to-GDP ratio back on track. Sounds like a great plan, but only on paper. In reality, the cost of this option would be another recession in 2013. In fact, the Moody’s Analytics model of the US economy shows that going over the cliff would cut real GDP by 3.6%, below what it would be if current policies were extended next year. This outlook may be optimistic, but the risks are definitely greater on the downside. The US economy is pathetically fragile at the moment. While unemployment rate is still over 8%, the trend in the three months through October shows manufacturing down more than 3% year-on-year, the worst outcome of the recovery till date. In fact, there are several such scenarios which can nullify the initial positive effect on fiscal sustainability.
It’s been just three weeks since US President Barack Obama won the re-election, but a doubt whether he can forge a productive second term in a divided political system has already started doing the rounds across political arenas. No doubt, the Presidency is settled, but little else is. Policy uncertainty has been one of the biggest obstacles to Uncle Sam’s economic growth over the past few years, and the outcome of the recent Presidential election is unlikely to change much. The scenario could become even worse as Washington’s fiscal debate intensifies. Reason: President Obama has two big decisions to make and that too by early 2013.
The first is what to do about the so-called fiscal cliff – the substantial tax increases and government spending cuts scheduled to hit next year under current law. The second is how to achieve fiscal sustainability; that is, what long-term tax and spending changes will make future budget deficits small enough so that the nation’s debt-to-GDP ratio (103% of US GDP) stabilises. What Obama decides today will determine how the US economy performs tomorrow.
The fiscal cliff describes what will happen if the Bush-era tax cuts, this year’s payroll-tax holiday, and the emergency unemployment insurance programme all expire on schedule, just as government spending drops according to the terms of last summer’s deal to raise the Treasury debt ceiling. Those would be on top of several temporary tax and spending adjustments that Congress normally extends each year, affecting the Alternative Minimum Tax (the so-called “AMT patch”) and Medicare’s reimbursement schedule for doctors (known as the “Medicare doc fix”). If policymakers do nothing before the end 2012, the resulting tax increases and spending cuts will total $715 billion in 2013, equal to about 4.3% of GDP.
Fiscal sustainability is attained when a country’s debt grows in tandem with its GDP. The Great Recession, by contrast, resulted in a near doubling of the US debt-to-GDP ratio over the past five years. If the fiscal policy remains unchanged, the debt load will continue to outpace growth, eventually triggering an economic crisis. Under reasonable economic assumptions, Obama needs to reduce the annual budget deficits by $3 trillion over the next decade to attain fiscal sustainability. This amount includes the $1 trillion in spending cuts agreed to as part of last summer’s increase in the Treasury debt ceiling, but not the $1 trillion in automatic spending cuts, known as sequestration, that also were part of that deal. If Obama makes these necessary changes, deficits by 2020 will equal no more than 3% of GDP. Given the expected pace of GDP growth, that will stabilise the debt-to-GDP ratio.
Going by this logic, the solution to Uncle Sam’s problem seems to be simple. Obama should decide to do nothing, stick to current law, and let the nation go over the fiscal cliff. This would solve the fiscal sustainability problem: Higher tax revenues and lower spending would make future budget deficits small enough to bring the debt-to-GDP ratio back on track. Sounds like a great plan, but only on paper. In reality, the cost of this option would be another recession in 2013. In fact, the Moody’s Analytics model of the US economy shows that going over the cliff would cut real GDP by 3.6%, below what it would be if current policies were extended next year. This outlook may be optimistic, but the risks are definitely greater on the downside. The US economy is pathetically fragile at the moment. While unemployment rate is still over 8%, the trend in the three months through October shows manufacturing down more than 3% year-on-year, the worst outcome of the recovery till date. In fact, there are several such scenarios which can nullify the initial positive effect on fiscal sustainability.
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