The Wrongologist

What’s Wrong Today:

Now that
the results of the election are so 12
hours ago, the pundit class has moved on to arm waving about the Fiscal Cliff. 

“Fiscal Cliff”
is shorthand to describe the
conundrum
that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to
go into effect, which, unless changed, will result in tax increases, spending
cuts, and a corresponding reduction in the budget deficit.  These laws include tax increases due to the
expiration of the Tax Relief,
Unemployment Insurance Reauthorization, and Job Creation Act of 2010 and the spending
reductions (“sequestrations”) under the Budget Control Act.

The
year-over-year changes for fiscal years 2012-2013 include a 19.63% increase in
revenue and 0.25% reduction in spending.

Some major
domestic programs, like Social Security, federal pensions and veterans’ benefits, are exempted from
the spending cuts. Spending for federal agencies and cabinet departments, including
defense, would be reduced through budget
sequestration.

With the
sequester, the 2013 deficit is projected to be reduced by roughly half, with
the cumulative deficit over the next ten years to be lowered by as much as $7.1 trillion.

However, pundits
and politicians are frightened that the Sequester may cause a double-dip
recession
in the first half of 2013.

The Budget
Control Act of 2011 was passed in a political environment of stalemate, since Democrats
and Republicans could not agree on how to reduce the deficit. It was thought
that the blunt cuts of budget sequestration and sharp revenue increases would
be undesirable to both parties and provide
an impetus and deadline to bring the sides together to solve the deficit
problem.

Additionally,
the debate may be exacerbated by the expectation that the debt ceiling may be reached before the end of 2012.

In dealing with the Cliff, lawmakers will
probably choose from among three options:

• Let the current policy go into
  effect at the
  beginning of 2013. (or, “Drive of the Cliff”)The Negatives? The associated tax increases and
  spending cuts could drive the economy back into recession. The positives? The deficit as a % of GDP would be
  cut in half

• Cancel some or all of the scheduled
  tax increases and spending cuts,
  which would add to the deficit and increase the odds that the United States over
  the longer term, could face a crisis similar to that which is occurring in Europe as our federal debt continues to
  grow.

• Opt
  for a moderate approach.
  Address the budget issues to a limited extent. Let’s call this the “small bites” menu, reduce spending
  a little, increase taxes a little, which would have only a modest impact
  on growth.

So,
What’s Wrong?

Wait! They’re not considering the
“Grand Bargain?”
In an interview with
the Des Moines Register on Oct. 23, Mr. Obama predicted he and Republicans
would come to the equivalent of the “grand bargain” that he has been trying to
work out with the GOP. He has proposed
$4 trillion of deficit reduction over 10 years.

Why not? Even Mr.
Obama doesn’t think it can’t get done by year end. He said:

“We’re going to be in a position where
I believe in the first six months we are going to solve that big piece of
business”.

In other
words, not likely by year end.
So both congress and the president will drive off the cliff like Thelma and
Louise and then walk it back
after the public and business go nuts, or they cut some kind of temporary deal.

Is the
Fiscal Cliff Really a Fiscal Disaster?

It’s
important to keep in mind that while the term “cliff” implies a disaster at the
beginning of 2013, the actual impact
of the changes will be gradual at first.

What’s
more, Congress can change the law retroactively, after the deadline. As a
result, the Fiscal Cliff won’t necessarily be an impediment to growth even if Congress doesn’t address the
issue until after 2013 has already begun.

Another
factor pundits are ignoring:

In terms of government spending, we have already
driven off a cliff.  And we lived.

Falling government spending has constrained
our GDP growth in 9 of the past 11 quarters (see the graph below from Fisher
Investments Research). However, private sector growth has been
more than robust enough to keep overall growth positive.

The next hundred words include a few
numbers:

The Sequester
may cut as much as $65 billion in fiscal year 2013 (which ends next September
30). By that point, US GDP is projected to be at $12.225 trillion ($16.34 for
the calendar year 2013). If government projections are right (they won’t be)
and politicians do nothing (they will do something), the Sequester might reduce GDP by -0.53%. Not great, but that’s better than in FY2011,
when declining government spending reduced GDP by -0.67%. And full-year real
GDP still grew by 1.8%.

This means we are likely to have GDP growth
in FY 2013, not recession.

If we
subtract another $25 billion that will automatically be cut from expiring
jobless benefits, spending cuts may reduce
FY 2013 GDP by up to -0.73%. Still not a recession or anywhere near a
disaster.

Maybe we should call it a fiscal inclined
plane, not a fiscal cliff.

There are political
signs of a deal that could make both sides somewhat happy. Mr. Obama tipped his
hand in the last debate with Mr. Romney when he said flatly that the defense cuts “will not happen.”
Moreover, Vice President Biden’s repeated use of a $1 million threshold for
higher tax rates in his own debate with Paul Ryan suggested Democratic wiggle room on the revenue side of the cliff.

Interestingly, the
Sequester that creates the Fiscal Cliff amounts to $2 of tax increases for each
$1 of spending cuts. The Republicans could have taken the Mr. Obama’s original 1-to-10
offer. But, they rejected it.

Finally,
an unremediated Fiscal Cliff could hit the Defense industry hard. Their lobbyists and captured
congressmen are warning that upwards of 2.5 million jobs could be lost (an exaggeration), and the
economy crushed in the process.

It is hilarious to
hear conservatives, who have spent the last four years saying that government
spending doesn’t create jobs, now saying that defense spending cuts will destroy jobs.

Really, conservatives continue to demonstrate
that they have nothing, zip, nada, to contribute to the conversation about the
economy.

Ignore them.