The Fiscal Cliff Provides a Window of Opportunity

Citi GPS Opinion Article

27 December 2012 – It has been said that the working definition of insanity is to do the same thing over and over again while expecting different outcomes. As we survey the key players in the ongoing fiscal cliff negotiations, it is striking that this is precisely the same cast of characters that brought us the stresses and disruptions with the debt ceiling in the summer of 2011. With the onset of the fiscal cliff now just a few days away, are there any good reasons to believe that this time might be different?

One important point is that in the present episode there seems to be an admittedly unsettling, but possibly effective, “balance of terror” between the two parties. On the one hand, Republicans are uncomfortable with the composition of the fiscal cliff, as it entails higher taxes and lower defense spending. Such measures are clearly distasteful to the party of Ronald Reagan.

On the other hand, federal borrowing is again facing the cold realities of the debt ceiling. The Tea-Partiers in Congress would shed few tears if the government was temporarily closed and new borrowing was halted. But such an outcome is unpalatable to Democrats and especially to the President, who as Chief Executive is responsible for the smooth operation of the government. (Note that Republicans did not threaten to close the government during the tenure of George W. Bush.)

Thus, over and above the risks of economic and financial stresses, each of the parties has philosophical incentives to reach compromise. A corollary is that any meaningful agreement will need to address both the fiscal cliff and the debt ceiling. But, as we observe the tortured ebb and flow of these negotiations, the open question is how long it will take the two parties to move beyond the political trench warfare that has forestalled progress on these issues for years.

With January 1st fast approaching, a further point is that — over a long horizon — the details of an agreement will prove every bit as important as exactly when the agreement is reached. Many commentators have documented that the federal government’s debt position is on unsustainable footing. This is not new news. But what is important is that the “balance of terror” that I have described, also provides an opportunity for broader action toward U.S. fiscal sustainability.

A few numbers motivate this observation. At present, federal government debt held by the public is between 70 and 75 percent of GDP, up a hefty 35 percentage points since the onset of the financial crisis in 2007. By our reckoning, merely stabilizing the debt at these high levels would likely require measures — best implemented gradually over several years — to reduce the fiscal deficit by roughly 2 to 2 ½ percent of GDP, or more than $3 trillion over ten years. Bringing the debt down to pre-crisis levels would demand even bolder actions.

To date, even the most promising packages that have been put forward in the ongoing negotiations fall well short of these benchmarks under realistic accounting.

Beyond the size of any package, the composition of the retrenchment is also of great importance. It is only a slight overstatement to say that, if entitlement spending is not meaningfully reformed, the federal debt will eventually become unsustainable almost regardless of what else is done. Similarly, as the baby boomers retire, higher tax burdens appear unavoidable, at least if we desire to maintain defense spending and anything approaching present levels of discretionary programs. The bottom line is that addressing the government’s debt sustainability problems is likely to require both reducing expenditures and increasing tax revenues.

Achieving this fiscal consolidation will require difficult concessions from both parties. But the stark realities and risks that surround the fiscal cliff and the debt ceiling seem more likely than in calmer conditions to generate meaningful compromises. In this sense, the fiscal cliff provides a window of opportunity — and strong incentives — to make progress toward needed fiscal retrenchment.

The converse of this observation is also true. If progress on debt sustainability is not achieved in the present negotiations, as painful and difficult as they are proving to be, there is little reason to believe that politicians will come back in the months ahead and make tough concessions simply because it is the responsible thing to do.

These arguments are admittedly clouded by political considerations. There are a range of views as to who exactly would be blamed by the public if a plunge down the fiscal cliff does occur. But there is enough uncertainty on this score that neither party should be keen to find out.

Recent signals from the economy, especially signs of renewed life in the housing market, suggest that a stronger recovery may finally be taking hold. But these encouraging developments could yet be snuffed out by missteps on the fiscal cliff. Similarly, a failure to address the government’s longer-term debt-sustainability problems would pose more long-lived risks for the economy — and for the dollar’s role as the global reserve currency. It is incumbent on the political process to seize this opportunity and address these serious risks.