All you need to know about the fiscal cliff which will savage the US economy in under 5 months, unless Congress finds a way to compromise at a time when animosity and polarization in congress is the worst it has ever been in history.
The cliff in graphics:
The cliff in numbers:
And a Q&A from Goldman with its DC political economist Alec Phillips:
What is the “fiscal cliff”?
Alec: It’s the unhappy coincidence of about $600bn in tax increases and spending cuts that come about on January 1, 2013. Last year, we started calling this the “fiscal cliff.” On the tax side, the most significant policies are the income tax cuts enacted in 2001 and 2003, and the payroll tax cut that has been in place for the last two years. The spending cut comes mainly from the “sequester,” with a smaller effect from the expiration of expanded unemployment benefits.
What do you mean by the “sequester”?
Alec: When Congress raised the debt limit last year, the bill it passed included over $2 trillion over ten years in projected spending cuts, from capping annual spending bills and a flat $109bn per year cut in spending known as the “sequester” that would take effect if a deficit reduction “super committee” failed to agree on $1.2trn in savings. The super committee failed, so now the sequester is scheduled to cut spending at the start of 2013, applied equally to defense and domestic spending.
How does the debt limit fit in?
Alec: It’s indirectly related to the fiscal cliff, since Congress will need to address it either at the end of this year or early next year. The debt limit is a legal cap on the amount of debt the Treasury can issue—it currently stands at $16.4 trillion—and covers publicly held debt as well as debt in the Medicare and Social Security trust funds. We think the limit will become binding on the Treasury by February 2013, though hopefully Congress will raise it when they deal with the fiscal cliff at year end.
What happens if the debt limit isn’t raised?
Alec: The Treasury brings in about $200bn each month, but pays out about $300bn, so it would be able to pay most but not all of its bills, with missed payments going into arrears. For some areas a sort of “first in first out” system might make sense, but it seems likely that the Treasury would prioritize interest payments.
What would be vulnerable to cuts in this situation?
Alec: Payments to federal employees, contractors, and health providers under Medicare would probably see effects right away. States, which receive hundreds of billions per year in federal grants, could also see a reduction in revenues. Social Security and other types of payments would probably also be delayed.
What are the key dates ahead for these issues?
Alec: The House recently voted to extend the 2001/2003 tax cuts in their entirety, and the Senate voted to extend the tax cuts on income under $250,000. Spending authority will need to be extended for the coming fiscal year before the current one ends on Sep. 30, but that looks fairly likely to happen without too much controversy. The election on November 6 will be the next key date, after which Congress is expected to come back and deal with the fiscal cliff, but any resolution most likely won’t occur until the end of December. If there is no resolution by then, Congress may come back early in 2013 and address it retroactively. We expect to hit the debt limit in February, which is around the same time that the semiannual interest payment on Treasury debt is due (see Page 3).
Will the election influence how this gets resolved?
Alec: Yes. Overall, the Republican position is to extend all of the income tax cuts and to avoid the defense cuts. Most Democrats prefer avoiding defense and non-defense cuts, and would like tax revenues to replace some of the lost savings from doing so. They also oppose extending the income tax cuts on upper incomes.
Will the election influence when this gets resolved?
Alec: Probably, but it’s not clear in which way. A clear-cut election victory by either party could hasten an agreement, while a close election could lead to a more protracted debate. On the other hand, if one party—the Republicans, for example—were to gain control of Congress and the White House, they might opt to delay action until they gain control 2013 if they can’t win concessions in 2012. A status-quo election outcome—i.e., the President wins reelection and the Democrats hold the Senate—might make an agreement in the lame duck session of Congress more likely. Of course, there is no clear-cut answer in any of these scenarios.
Will the fiscal cliff happen?
Alec: It’s not our central expectation. We assume that Congress will act in the lame-duck session after the election to extend most of the current policies until sometime in 2013. A three-to-six-months extension would allow them to address the debt limit and provide some time to come up with a longer-term fiscal plan that may involve tax reform and/or entitlement (Social Security/ Medicare) reform. The only part of the fiscal cliff that we expect to take effect at year end is the expiration of the payroll tax cut (because there seems to be broad agreement that this will eventually need to expire), along with continued phase down of emergency unemployment benefits.
What are other scenarios and their probabilities?
Alec: You have two general scenarios, one is that they extend the policies past the end of the year and the other is that they don’t. We think the odds that the fiscal cliff is allowed to take effect at the end of the year are probably about one in three. If that happened, Congress would probably step back in 2013 and reverse some of it, though even a temporary lapse could be disruptive for markets and the real economy. A long-term agreement before year end (i.e., longer than a full year) seems to be the least likely outcome.
Will the debate be cleaner or messier than last year?
Alec: Messier. First, the issue is just bigger. Last year, we just had the debt limit, whereas this year we have that same threat plus the fiscal cliff. Also, in order to resolve the issue last year Congress was able to agree to lower overall spending levels withoutspecifying where those cuts would come from. Now that those “easy” savings have been used, the options left are more specific spending cuts or tax increases that are more politically painful. Also, some politicians may find it advantageous to let the tax cuts expire, which would enable them to come back next year and enact tax relief on a smaller scale than exists currently. Even though it would lead to an overall increase in revenues, this would allow them to cast a vote to cut taxes next year (once rates have increased) rather than a vote to raise them this year.
What is the economic impact of your base case?
Alec: We assume a drag on GDP growth from fiscal policy of about 1.5% in 2013, due to the expiration of the payroll tax cut along with some smaller factors. Even if Congress extended everything, we think that federal fiscal policy would still weigh slightly on growth, particularly since federal spending is slowing.
What would the impact be of falling off the cliff?
Alec: If Congress took no action, we estimate around a 4% hit to GDP growth in 2013. If you assume an underlying trend of around 2.5%, that is likely to put the economy into recession. There might be some mitigating factors: Consumers might initially tap savings or borrow and not all of the federal spending cuts would kick in on day one. It is also possible that some business investment or hiring has already been delayed and could restart once the uncertainty has passed. But overall, letting these policies lapse all at once would be a very negative outcome. Of course, a short lapse that the new Congress quickly addresses in January would do less damage to the economy, though damage to policy credibility and markets might still be significant.
What is the Fed’s role here, if any?
Alec: In our base case we already assume that the Fed is going to ease policy in September, with renewed balance sheet expansion late this year or early in 2013. If we fall off the cliff in a more significant way, then the likelihood of easing and the magnitude of this easing would go up. But the Fed can’t offset a fiscal contraction of the size we’re talking about.
What sectors would be most impacted?
Alec: Defense and healthcare are the most obvious sectors, because they have relatively large shares of revenue from the Federal government, and they are also two places that the sequester is scheduled to hit hard at the end of the year if Congress doesn’t act. The cut to defense spending in particular would be almost certainly greater than 10% and may be closer to 20%. The fiscal cliff would also hit consumers’ disposable income, which is an important distinction with last year’s debt debate, in which most of the policy discussions were confined to a narrow set of industries and had little direct impact on consumers.
How concerned is the market about these issues?
Alec: To assess this, you can look at a basket of stocks that our colleagues in equity research have put together, which tracks
companies with large shares of government-related revenue. This index dropped very significantly on a relative basis to the S&Pabout a month ahead of the debt limit last year and it never fully recovered. We are starting to see some of that again this year, but the magnitude is obviously not the same so far. The other area where you would expect to see it is in consumer onfidence and we have seen some weaker confidence numbers recently, though, again, nothing like we saw around the debt limit last year.
Allison: Will the market react sooner this time?
Alec: Potentially, but it’s unclear. Last year we saw a clear reaction to the debt limit debate only about a month before the deadline. One would imagine the reaction this year would come further in advance of the event, since it’s a bigger issue and also because there are plenty of people who were caught off guard by last year’s developments and might be more proactive this time. That said, my sense is that many in the market are withholding judgment until the election happens, because it’s just so hard to predict before then how all of this will be resolved. That could mean a sharper reaction post-election, depending on the situation.
Will the US be downgraded again this year?
Alec: Probably not. It wouldn’t make much sense for the rating agencies to take a strong view on fiscal sustainability just ahead of the election and resolution of the fiscal cliff. They have implied as much in their recent commentary. That said, I believe the risk of a downgrade reemerges again next year, depending on how these fiscal issues are resolved. If a longer-term fiscal agreement either doesn’t happen next year and Congress continues with a sort of muddle-through approach, or if the agreement is just not as substantial as some would expect it to be—i.e., they aren’t able to stabilize the projected debt/GDP ratio by later in the decade—then a downgrade seems possible.
Will this series of events ultimately serve as a positive catalyst for longer-term fiscal reform?
Alec: Hopefully. The good news is that both parties seem optimistic that tax reform will be enacted next year. If it happens, it could also allow for entitlement reform. The bad news is that they need to bridge fundamental disagreements to get there. They are also working from a smaller segment of the budget—neither party appears comfortable with significant cuts to Social Security or Medicare in the next decade, and they disagree on how to handle taxes and some other areas of the budget. That doesn’t leave a lot of areas of the budget to work with to achieve savings.