Polarized politics in Washington have produced a deadlock over fiscal adjustment; a return to pragmatism is essential
How seriously should we take the fiscal cliff? Ben Bernanke first used the phrase in January 2012. The deadlock between the White House and Congress over how to deal with the mounting fiscal deficits of the previous decade postponed any decision until after the November presidential elections.
Elections have now passed but haven’t resolved anything, merely confirming the division of power between Republicans and Democrats in Washington. If nothing can be agreed by December 31st major tax cuts will automatically lapse, and there will be deep spending cuts in all federal programmes, including welfare and defence. This could provide a sizeable deflationary shock at a time when the weak recovery is just getting established.
The idea that US politicians could inflict such harm on the economy because of a failure to compromise seems so bizarre that many observers assume it will not happen. There will be a last minute deal, or another postponement of the need to make a decision.
The fiscal cliff is a product of the deadlock in Washington. It’s a creation of the politicians themselves rather than an objective feature of the public finances, a symptom of political polarisation and the increasing unwillingness of US politicians to reach pragmatic deals. The kind of deals that were once the hallmark of Washington politics and are essential if the constitutional division of powers is not to produce policy gridlock.
It’s wrong to think the conflict is between fiscal conservatives on one side and fiscal populists on the other. Both Republicans and Democrats are in practice fiscal populists, committed to deficits as a way of life, but they disagree over who should foot the bill.
The Republicans are proving most intransigent with their refusal to accept any increase in taxes for those Americans earning more than $250,000 a year, or indeed any significant new taxes at all. Instead, they wish to put the whole burden of adjustment on to spending cuts, but not across the board spending cuts, because most Republicans are committed to increasing defence spending. The prime target of the cuts will therefore be welfare, but again not welfare in general, but welfare programmes which support the poor. Programmes like Medicare, which support many middle income Americans, will be protected.
The Ryan plan supported by House Republicans implies the shredding of all federal programmes except for defence and Medicare. Even so as Matt Miller has pointed out, the Ryan plan would not restore fiscal balance. It would shrink government but the deficits would continue and national debt would rise. The Tea Party praised Andrew Mellon extravagantly for his policies during the Great Crash but Mellon was a true fiscal conservative who had no hesitation in increasing taxes to restore fiscal balance. The Tea Party are small government conservatives who above all want to cut down federal programmes except for the ones they benefit from directly. Protecting tax cuts is more important to them than sound money.
Underlying all of this is a problem no-one wants to confront; since the Reagan era, the US Government has persistently wanted to spend more than it has been prepared to raise in taxes. Republican Administrations have been the worst offenders. Reagan cut taxes while boosting spending, but supply side policies didn’t generate enough extra tax dollars to pay for the big increases in military spending that he sanctioned. By 1992 the external debt had reached $3 trillion.
Clinton ran budget surpluses but the debt accelerated again under George W. Bush, particularly as a result of the War on Terror after 9/11. It then ballooned further under Obama in the aftermath of the 2008 crash, which pushed tax revenues down to 14 per cent of GDP while increasing spending. By 2013 the debt had reached $15 trillion, and the annual deficit was running at 10 per cent of GDP.
From one angle this doesn’t matter so long as there are individuals and foreign governments willing to lend to the United States. While the dollar remains the world’s leading currency it will always be a safe haven. But this now means that foreigners currently hold half of US debt, in particular foreign governments, notably Japan and China. The involvement of China makes the US security establishment nervous, particularly since the Washington deadlock may produce further deep cuts in defence spending.
The slogan of the Tea Party is ‘cut, cap and balance’. They want cuts in spending, a cap on the debt ceiling, and a balanced budget amendment, which would remove discretion from the Federal Government to run fiscal deficits, even or perhaps especially during recessions. The rhetoric is extreme, even from moderate Republican Governors like Mitch Daniels of Indiana or Chris Christie of New Jersey. Daniels has called the federal government ‘morbidly obese’ and said it needed not just behaviour modification but ‘bariatric surgery’.
All sides agree that the United States faces serious fiscal challenges even without the financial collapse and the recession. A couple retiring in 2011 earning $89,000 a year would have paid $114,000 in Medicare payroll taxes, but can expect three times that in medical services. In social security what people pay in and what people get out is much more nearly in balance, but this is expected to change once more of the 70 million baby boomers reach retirement.
Sense of entitlement to Medicare is very strong, even among some members of the Tea Party, but paying for it is a huge problem for future US Governments. Total liabilities of all programmes are estimated at $61 trillion. A long period of stagnation in the economy will make the task of affording the entitlements that citizens have been promised that much harder.