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The Fiscal Ditch

The US elections are over. The Democrats retained control of the White House and the Senate. The Republicans kept control of the House of Representatives. The government, therefore, remains divided. Neither party has the votes required to drive through its own political agenda. How then will this divided government prevent the US economy from falling off the “fiscal cliff” just six weeks from now?  How this crisis is resolved will have an extraordinary impact on the US and, therefore, the global economy. So let’s consider how this political drama is likely to play out.

First of all, what is this fiscal cliff? At the end of this year, based on current laws, taxes will increase sharply and government spending will be reduced. As a result, the US government’s budget deficit will be $612 billion in 2013.  That will be $607 billion (or 3.8% of GDP) less than this year. This combination of higher taxes and reduced government spending will have an extraordinarily harmful impact on the US economy. In fact, if these laws are implemented, it is certain that the US economy will contract sharply and that unemployment will soar. The scale of this new economic slump could match the economic crash of 2009. The effects of reducing the budget deficit from $1,171 billion to $612 billion in just one year would be akin to pushing the economy over a cliff. It would result in a very hard landing.

As discussed in earlier blogs, every economy is made up of just four parts: personal consumption expenditure, business investment, net trade and government spending. In the US, those components contribute roughly 71%, 12%, -4% and 20% of GDP, respectively. Higher taxes would hurt the economy in a roundabout way by reducing consumption and business investment. Reduced government spending would directly shrink the size of the economy.

Therefore, if implemented, this $607 billion reduction of the budget deficit would cause the economy to be $607 billion or 3.8% smaller than it would have otherwise been – before the Multiplier Effect. When the government spends more (or taxes less), jobs are created, leading to more consumption and investment. Conversely, when the government spends less (or taxes more), jobs are lost, causing consumption and investment to decline. The impact of a change in government spending is therefore greater than the change in the amount spent. This is known as a Multiplier. The Multiplier is not always the same. It varies depending on the particular economic circumstances of any given time. 

Today, in my assessment, it would reasonable to expect the Multiplier to be approximately 1.5 times. If that is correct, the impact of a $607 billion reduction in the budget deficit would be $607 billion multiplied by 1.5, or $910 billion. That would mean the US economy would be 5.7% smaller in 2013 than it would have been if the size of the budget deficit had remained unchanged. 

The US economy is already very weak. It will grow by less than 2% in 2012 despite massive fiscal and monetary stimulus. It will remain very weak in 2013. Even if the economy does not go over the fiscal cliff, it is likely to grow by considerably less than 2.5% next year. Here, let’s assume (optimistically) that the economy would grow by 2.5% in 2013 with no change in the level of the budget deficit, and then deduct 5.7% for the impact of the fiscal cliff. In that scenario, the economy would shrink by 3.2% next year. That contraction would be slightly worse than the 3.1% contraction in 2009. The unemployment rate would move back up toward double digits. Corporate profits would be slammed. The stock market would fall sharply and the housing market would tank. In other words, it would be an economic disaster. That disaster would affect not only the United States but the entire world since very weak US demand would cause US imports and, therefore, global trade to contract sharply.

No one wants that to happen, so a compromise between the political parties will have to be reached. What form will that compromise take?

Both parties claim they want to reduce the budget deficit (although, in reality, neither side wants to reduce it too quickly). The Democrats want to reduce it by increasing taxes on the rich. The Republicans want to reduce it by reducing government spending on the poor.  The Democrats seem to be in a stronger position because if the current laws go into effect, the hit to the wealthy Republican constituency will be greater than the hit to the Democrat constituency (although both groups would be worse off). 

Of the $607 billion scheduled reduction in the budget deficit, $399 billion would be due to higher taxes and $103 billion from reduced spending. Out of the $399 billion increase in taxes, roughly 76% would be borne by the higher income groups, while only 24% would be paid by the middle class and the poor (in the form of a 2 percentage point increase in payroll taxes).

Out of the $103 billion reduction in spending, according to my estimation, roughly 75% would negatively affect “business interests”, while 25% would affect the middle class and the poor (through the termination of emergency unemployment benefits). 

Thus, it seems that the wealthy Republican constituency has more to lose than the middle class and poor constituency of the Democrat Party. Given that the Republicans have more to lose and given that they just lost the election, they are in the weaker position going into these negotiations. Therefore, they will most likely have to accept some higher taxes on the wealthier segments of society. 

Here’s what I expect will happen. The parties will agree to avoid falling over the fiscal cliff. The budget deficit will be reduced by something like $100 billion instead of $607 billion. Most of the $100 billion reduction will come from higher taxes on the wealthy, but that tax increase will be much less than those that would go into effect without a compromise. Most (if not all) of the payroll tax cuts will be extended and most of the emergency unemployment benefits will be extended. There will be little actual reduction in government spending.

If my guess is right, a $100 billion reduction in the budget deficit will be more like a fiscal ditch than a fiscal cliff. That sum amounts to 0.6% of GDP or 0.9% of GDP after a Multiplier of 1.5. That will knock off 0.9% from my optimistic (best case) forecast for next year’s GDP growth of 2.5%, resulting in 1.6% GDP growth in 2013.

In that scenario, the economy, employment and corporate profits will remain weak. Additional Quantitative Easing from the Fed will be required to prevent an even weaker outcome. I expect the Fed will soon double the amount of money it creates to $80 billion a month.

This outcome is far from ideal, but under this scenario, we should be able to avoid plunging back into severe recession next year. That is my best guess of how things will play out. 

One final word: for the sake of brevity, I have resorted to many generalizations and simplifications in today’s blog. For instance, not all Republicans are wealthy. Not all Democrats are middle class or poor. Moreover, the economy is much more complex than my back-of-the-envelop calculations employed here would suggest. I ask the reader to keep in mind that I try to limit these blogs to 1,000 words. This one is approaching 1,300 already.

Hopefully, these generalizations and simplifications have not too greatly undermined the validity of my analysis.

For a very detailed explanation of these issues, visit the website of the Congressional Budget Office. Here’s the link: http://www.cbo.gov/publication/43694