The US "Fiscal Paraglide"

First off, Merry Christmas to all the readers of my blog, and may you also have a Happy, Healthy and Prosperous New Year!

I am currently out in the middle of Indian Ocean (just sailing towards Madagascar passed Reunion Island an hour ago) this Christmas Eve night, having spent a wonderful 3 days on the island of Mauritius.  While cruising the south Indian Ocean I have been reading the New York Times on virtually a daily basis and have been mesmorized by all the drama that unfolded in Washington DC over the past week or so connected with the so-called “fiscal cliff”.  So as there is only a week remaining to do anything about the approaching 

sequester that will happen after January 1^st, I thought it probably time to say something about it.

My immediate reaction to reading the news was to think “oh no, so if the US Senate democrats will not propose anything unless the Senate Republican leadership in the shape of Mitch McConnell undertake not to filibuster the measure put forward, how will that work, given that the Republicans just don’t seem to be able to unite their disparate factions?”  I think that we indeed are about to go over to the so-called “fiscal cliff”, and it is now likely that taxes will go up and that spending will be cut over the next few years. 

But then I started to think about this a little more deeply and I realized that there are a few things that are really important here from both an economic and a political point of view; first, US debt has already been downgraded over the difficulty in finding agreement over raising the debt limit - which caused the US to be in the situation that it is now in – and the world didn’t end; second, that the “fiscal cliff” will really not be a cliff but will act more like a “fiscal paraglide”; and third, that we are currently witnessing the end of the Republican party as we know it, and therefore a completely fractured political structure that will not lead to agreements on economics for many years to come. 

Let’s deal with each issue in turn.  First, the actual economic measures in the fiscal cliff and the size of the US national debt are not the most important issues – economic growth is.  The real issue is how does the US maintain the impetus behind US economic growth, and clearly tax hikes and spending cuts will not help, but these tax hikes and spending cuts are not exactly as draconian as those already implemented in the UK, and yet the UK has managed to totter on with anemic rates of economic growth despite the fact that further cuts were recently announced. What I’m really trying to say is that this is not a question of action, it is a question of timing.  The UK adopted fiscal austerity with increases in sales taxes and quite drastic reductions in spending just as the country was coming out of recession, which led to a “double dip” recession.  The timing in the UK was all wrong.  So the question is, given where the US is right now, can it withstand some small tax increases and cuts to military and some social programs right now, or is the economy already sputtering or heading into a private sector downturn?  I would argue that the US economy is now resilient enough to withstand some corrective fiscal action, particularly as even if President Obama manages to get a so-called “stripped down” bill agreed upon which leaves taxes for all but the wealthy where they currently are, the country will once again face raising the debt ceiling again in late February or March.  Also the Fed is still maintaining and in fact expanding what is already an extremely expansionary monetary policy that is tied to the labor market, so given that the housing market is definitely on a track to recovery, some corrective action to taxes and spending should not derail economic recovery like it did the UK.

In fact I believe that US economic growth impetus right now is being somewhat underestimated, so that if there is enough “upwind” to growth, the increase in taxes and the cuts to spending could restore some confidence that the country is once getting back on track with its fiscal policy and therefore (using a “paraglide” analogy), falling off the cliff might only at worst provide one quarter of negative growth followed by a strong cyclical upswing.

Last point – the Republican Party.  What has been distressing to watch in all this drama in Washington DC is that our politicians just don’t seem to be able to bridge their gaps anymore on fiscal policy, partly because the Republican Party appears so divided on what compromise (if any) is feasible ( - thanks mostly to Grover Norquist).  So if these gaps in fiscal policy cannot be bridged, we need a new mechanism to deal with fiscal policy-making in the largest economy in the world.  If the debt ceilings are maintained, then are we really going to impose periodic sequesters?  If debt ceilings are scrapped, what constraints should US fiscal policy have? 

More on this next time!