The Burning Platform

By Satyajit Das

Reuters

President Barack Obama and House Speaker John Boehner will try to reach a deal to avert the so-called fiscal cliff — the automatic federal spending cuts and tax hikes slated for Jan. 1 — just one of several major economic risks affecting investors.

SYDNEY (MarketWatch) — Going over the so-called fiscal cliff may, on the face of it, “improve” U.S. public finances, reduce the deficit and slow the rise of America’s debt mountain.

But the fiscal cliff will not of itself solve America’s large and deep-seated financial problems.

Absent political agreement, a series of automatic federal tax increases and spending cuts — the fiscal cliff — will be triggered on Jan. 1. Several temporary tax cuts will expire. These include President George W. Bush’s tax cuts on income, investments, married couples, families with children, and inheritances, which were supposed to expire in 2010 but were extended for two years by President Barack Obama.

Also, the payroll-tax cut of 2% and extended unemployment benefits for the long term unemployed (both implemented by the Obama Administration to stimulate the economy) would terminate, along with smaller tax cuts for individuals and business (most notably tax credits for research and development and a deduction for state sales taxes).

Meanwhile, automatic spending cuts will kick in, totaling about $600 billion per year and $6.1 trillion over 10 years. The spending cuts would affect most government programs, including a $55 billion cut in defense spending and $55 billion in domestic programs. Medicare, the federal health program for the elderly, would reduce payments by 2%, including a sharp reduction (as much as 30%) in reimbursements to doctors.

The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about 5% of GDP. In a recent report, the non-partisan Congressional Budget Office estimated that the tax increases and spending cuts would reduce output by around 3% and increase unemployment to 9.1%.

Negotiation and reform

Yet a decision does not have to be reached by the end of 2012. The Treasury can juggle its finances to buy time, perhaps until February, especially if an agreement is likely. The major constraint is the need to increase the government’s borrowing cap or debt limit (currently $16.4 trillion), which will be hit before year-end or early in 2013.

Necessary reform of the tax system, especially a broadening of the tax base, and all spending, including social welfare programs, is unlikely to be easy.

President Obama’s ability to implement policy is constrained by Republican control of the House of Representatives. Republicans are reluctant to entertain tax increases or reductions in exemptions. Democrats are reluctant to consider reductions in entitlements and spending. Read more: Kicking the fiscal can has advantages.

The president asserts that he has a mandate to reform the budget, particularly to increase taxes on wealthier Americans. Having lost the presidential election and also having failed to make hoped-for gains in congressional elections, Republicans are defensive. The GOP position is complicated by fractious internal politics. More conservative elements believe GOP presidential candidate Mitt Romney lost due to a shift to centrist policies, and that a return to more strict conservatism is required.

Satyajit Das

Republican House Speaker John Boehner has been conciliatory to the administration, signalling a willingness to consider some higher taxes. In the fissiparous world of U.S. politics, nothing is guaranteed, especially given the short electoral cycle. The prospects for a definitive, so-called grand bargain remain poor. The more likely scenario is an incremental, ground-game strategy. Read more Das commentary: Financial WMDs debase U.S. dollar, risk inflation.

A short-term compromise will be needed, entailing the extension of some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending. Read more Das commentary: Debt is drowning the American Dream.

President Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1 million per year (rather than the $250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated.

In return, the Obama administration may agree to changes in entitlement, such as a higher Medicare retirement age and changes to the indexation of Social Security benefits for inflation. There would probably also be cuts in spending on defense and other social welfare programs including Medicaid.

U.S. debt; global concern

But the measures that are likely to be adopted may not be enough to winnow America’s laundry list of fiscal problems.

What is needed is a radical overhaul of the U.S. tax system, including probably a value-added tax and rolling back complex deductions and subsidies. What is also needed is a review of all federal spending, including defense and social welfare, to better target expenditure and align it with tax revenues.

Even with such decisive action, without strong economic growth and decreases in unemployment it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that “[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary.”

This means that the U.S. will probably continue to spend more than it receives in taxes for the indefinite future, resulting in increases in government debt. This will force the Federal Reserve to continue existing policies, especially debt monetization by purchasing government bonds and the devaluation of the currency.

Given that the U.S. constitutes around 25% of global economy, it is unlikely America’s problems will stay in America. If the U.S. takes the decisive action suggested, then U.S. growth will slow sharply but the downturn would be brief in duration and the longer-term would look brighter.

If the U.S. does not take decisive action, which seems the more likely course, then U.S. growth would be less-impaired in the short run — but America’s debt position will become increasingly problematic.

America’s long-term growth prospects will also be adversely affected. Moreover, any slowdown in U.S. demand will affect China, Europe and other major U.S. trading partners, which in turn would have a detrimental impact on those economies’ trading partners.

In addition, U.S. dollar devaluation will pressure other nations to implement measures, such as zero interest-rate policies, quantitative-easing programs or capital controls, to halt or at least slow the appreciation of their currencies to avoid reductions in competitiveness. Foreign investors in U.S. dollars and government debt are likely to suffer losses on their dollar-based and government bond holdings.

In “Hamlet,” William Shakespeare’s tragic hero states that: “I must be cruel only to be kind; Thus bad begins, and worse remains behind.” In trying to preserve its competitive position, the U.S. now is increasingly adopting toxic economic and financial policies with the potential to damage other nations and ultimately America’s own future.

How long the U.S. can continue its profligate ways is unknown. But as economist Herbert Stein observed: “If something cannot go on forever, it will stop.”

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.