In his testimony over the last two days, Bernanke has listed the 'fiscal cliff' as one of the two greatest risks to the US economy, along with the situation in Europe, and urged Congress to enact 'earlier rather than later' a plan that achieves 'short-term and long-term objectives,' with the primary short-term objective to adjust the timing of the near-term fiscal contraction "to allow the recovery a little more space to continue." . However, like us, Goldman believes that resolving the two key issues - the fiscal cliff and the need to raise the debt limit - will be more difficult than it was last year, for three reasons: (1) the "easiest" options to lower the deficit have already been adopted, so the remaining options touch more controversial areas than those enacted last year; (2) some members of both parties have indicated that they regret the agreements reached in 2010 and 2011, implying less willingness to compromise this year, and (3) both parties appear to be contemplating strategies that involve allowing most or all of the policies to change at year end, as a means to achieving their ultimate policy goal.
Sure enough, as debate on the fiscal cliff gets underway in earnest, the tone of rhetoric has predictably worsened.
Given these challenges, Goldman still believes Congress will ultimately reach an agreement. Mainly because they do not believe that either political party will want to run the risk of imposing such a large amount of fiscal restraint, given the negative economic consequences that it would have. We suspect this will only occur after the market makes it clear that any other path is unacceptable.
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Goldman Sachs, US Daily: The Fiscal Cliff: Finding Middle Ground Will Be Harder Than Last Year
lawmakers may have more difficulty reaching agreement on fiscal matters later this year than it was in 2010, when Congress extended the expiring 2001, 2003, and 2009 tax cuts, or in 2011, when Congress raised the debt limit. There are three general reasons that the upcoming fiscal issues looks even tougher to resolve than the previous debates:
- The politically "easy" options to lower the budget deficit have already been used. Reaching a long-term fiscal agreement later this year or early next year is going to require additional budgetary savings. Last year's agreement was made possible by the fact that the $2.1 trillion over ten years in savings was not linked to specific programs; spending caps reduced the overall amount of projected future spending, but left specifics to future Congresses, while the cuts under the "sequester" received less attention because it was assumed that the congressional "super committee" would replace them before they took effect. This year, only the more politically difficult savings options remain. The table below shows revenue and spending levels under the Republican-authored House budget, the President's budget, and current policy extended. The columns on the right show how each segment of the budget would change under those options compared to current law, in which Congress takes no action and policies take effect or expire on schedule. The table highlights two important issues. First, neither party proposes substantial cuts to Medicare or Social Security spending over the next ten years. Second, neither party endorses the cuts under the sequester, implying that some budgetary savings might be used simply to replace those cuts, rather than generating new deficit reduction. The upshot is that the two parties have limited their deficit reduction options, for now, to a few controversial areas of the budget. House Republicans focus on cuts to Medicaid, the new health law, and other mandatory spending. The President generates most of the additional deficit reduction (beyond the discretionary cuts agreed to last year) from higher tax revenues.
- Members of both parties appear more hesitant to compromise after the experiences of 2010 and 2011. While one might imagine that the effects of the debt limit debate on financial markets and the economy, and the related US credit rating downgrade would lead lawmakers to seek an earlier compromise this year, this does not appear to be the case. Some Democratic lawmakers have indicated that they regret agreeing to extend the 2001/2003 tax cuts in their entirety in late 2010, and have implied they will oppose the next extension more strongly. Likewise, several Republican lawmakers have recently said that they regret agreeing to the Budget Control Act enacted in August to raise the debt limit. Now that the consequences of the sequester enacted as part of the BCA are coming into focus, members of both parties are likely to be wary of "triggers" meant to enforce whatever agreement that might be reached later this year.
- In certain scenarios, both parties perceive upside from allowing the fiscal cliff to hit. Senator Murray pointed out in her comments earlier this week that one political advantage of letting the tax cuts expire is that it would allow Congress to focus on debating how large of a "tax cut" should be enacted next year, since taxes would have already risen, rather than debating how large of a "tax increase" should be adopted. In a scenario in which Republican Presidential Candidate Mitt Romney were to win the presidential election and Republicans took a small majority in the Senate, Republican lawmakers may be inclined to let current fiscal policies lapse at least temporarily until the election results have taken effect in January.
For these reasons, it appears likely over the next few months that uncertainty regarding the outcome will persist and will probably increase. While there are only anecdotal reports of concern regarding the fiscal cliff weighing on investment decisions--the Fed's Beige Book, released this afternoon, included a few--over the next several months the risks around the year-end fiscal situation seem likely to weigh on public and market sentiment more heavily, particularly as the election nears and political rhetoric escalates.
Given these challenges, why do we think Congress will ultimately reach an agreement? Mainly because we do not believe that either political party will want to run the risk of imposing such a large amount of fiscal restraint, given the negative economic consequences that it would have. Beyond the economic reasons for wanting to avoid this, it simply is not clear who would be blamed for letting these policies lapse and we suspect that politicians in both parties will view the political risks--in addition to the economic risks--associated with letting the fiscal cliff take effect to be too great. Finally, most of these policies have been extended at least once before, and some have been extended several times. Since a short-term extension is possible and could be enacted explicitly as a means to reach a broader fiscal agreement in mid-2013, this would seem to be a less risky means of resolving the issue, while preserving whatever political advantages either party believes it has.