The last best hope

With the deficit-reduction committee’s failure, American fiscal policy is drifting in a dangerous direction

Nov 24th 2011 | WASHINGTON, DC |

THE failure by Congress’s joint select committee to produce a deficit plan was greeted with widespread disappointment, but little shock. Voters had long expected failure. Wall Street had predicted at best a small deal. Deprived of even that, stocks fell November 21st, the day the committee announced its failure, but soon turned their attention back to Europe.
Superficially the lack of alarm was understandable. The showdown between Republicans and President Barack Obama over the debt ceiling in August could have forced the federal government to renege immediately on its bills. In contrast, the law that established the “supercommittee” dictates that without a deficit plan, $1.2 trillion in spending cuts spread over domestic and defence programmes (a “sequester”) be triggered, but not until 2013.
However, the implications of the committee’s failure are more disturbing than the reaction of the markets has let on. It leaves a series of landmines in the path of the economy over the next 14 months while leaving America’s longer-term fiscal challenges unaddressed. It also further entrenches Democrats and Republicans in their opposing positions and thus less able to deal with either problem, not to mention any of the various other catastrophes threatening the global economy.

A sensible fiscal plan would couple modest near-term stimulus with long-term reforms to entitlement spending and taxes. Instead, America is getting the exact opposite. A legacy of patchwork budget-making and temporary tax cuts means as much as $360 billion in fiscal tightening, or 2.4% of GDP, could unfold over coming months (see table). A couple of the smaller items are almost certain to be overridden, such as a cut in Medicare fees and the effects of the non-indexation of the alternative minimum tax, both of which routinely get “fixed” and “patched” respectively. Mr Obama is also pressing to extend the 2% cut in the payroll tax and enhanced jobless benefits for another year. The Republicans seem receptive, but the supercommittee’s failure robs both sides of the tidiest vehicle for doing that.
Analysts at ISI Group, a stockbroker, put the odds that those last two measures will be extended again at a bit above 50%. But, ISI also notes, every dollar of stimulus extended now will add a dollar to the extent of the fiscal contraction felt a year later. Added to the expiry of George Bush’s tax cuts at the end of 2012, the sequester, and a new Medicare tax, would produce a crushing 2.6% fiscal hit in 2013, easily enough to tip the economy back into recession. And even though the deficit would be reduced, debt would remain on an upward path over the long term because of the rising bills for Medicare and Medicaid (health care for the elderly and the poor respectively) and Social Security (pensions), and interest payments.
Every attempt to solve these problems has so far failed, but the supercommittee had a fighting chance, thanks to the threat of the sequester and the agreement that its proposals could not be subject to either amendment or filibuster. Its six Democratic and six Republican members, drawn equally from the Senate and House of Representatives, by most accounts got along swimmingly, at various times watching football, cycling, singing “Happy Birthday” and eating beef jerky together.
Conflicting explanations for the failure of the committee, which met in private, have emerged, but the main stumbling block, as usual, was taxes. On October 25th, Democrats proposed a $3 trillion deficit reduction package, including $1.3 trillion in increased taxes, and some cuts to entitlements, such as increased contributions by affluent beneficiaries to Medicare. Republicans termed the revenue demands too steep. Then on November 7th Pat Toomey, a Republican senator from Pennsylvania, proposed a $1.5 trillion package including $250 billion in higher taxes from reducing tax deductions.

Some Democrats saw Mr Toomey’s proposal as a promising departure from Republicans’ decades-old opposition to tax increases in any form. But the closer they looked, the less they liked it. Mr Toomey would not only lock in Mr Bush’s tax cuts for ever, but lower rates further. The top rate would drop to 28% from 35%, and the 15% lower rate on capital gains and dividends would become permanent. The result would be big tax cuts for a few rich households, who do not benefit much from tax deductions, and increases for middle and upper-middle income taxpayers, who depend upon them. That was anathema to Democrats, who want the wealthiest to pay more, not less.
Republicans claim Mr Toomey’s revenue plans were flexible. Not flexible enough, according to Democrats. “Whether it was meant that way, the reality is [Mr Toomey’s proposal] became a take-it-or-leave-it,” says Chris Van Hollen, a Democratic congressman and supercommittee member. “The Republicans never moved off that position.”

Mr Van Hollen does not question the good faith of his Republican counterparts. The problem is that the two parties’ sincerely-held views about politics are so far apart. “We could not bridge the gap between two dramatically competing visions of the role [of] government,” said Jeb Hensarling, a Republican congressman and the committee’s co-chairman, in a newspaper article.
What now? Republicans are already drawing up proposals to protect defence from the sequester, but Mr Obama says that he would veto any such attempt. Both sides are preparing to fight next year’s election over those differing visions, so the odds of a resolution to the Bush tax cuts, the sequester, and entitlements before then are close to nil. (What happens after November 6th 2012, though, is anyone’s guess.) Last August, Standard & Poor’s shocked markets and politicians by stripping America of its AAA credit rating because of the debt ceiling stand-off. Fitch and Moody’s, the other main ratings agencies, have refrained from doing so, in part because of the promised deficit reductions under the sequester.
As Steve Hess of Moody’s notes, the committee’s failure to enact more sweeping reform cost America an opportunity to remove the shadow over its AAA rating. “At this point we’re factoring into the outlook no significant deficit reduction measures until after the election. And that’s because of the legislative environment.” Election years have always carried above-average risks of financial crisis because governments are too scared to take the painful steps necessary to fix the underlying problems. That is true in spades for 2012.