Against the tide: Climbing the fiscal cliff


David Roche
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The mini-deal reached to avert the US fiscal cliff offers no solution to excessive public borrowing, which has to be dealt with by the end of this month.

Last month, the fiscal cliff in the US economy was averted by a mini-deal agreed between the Obama administration and the Republican-controlled House of Representatives. However, the deal left more questions unanswered than solved. The Bush tax cuts have been extended for all except the top 1% of taxpayers. So in terms of tax increases, a fiscal cliff for most Americans has been avoided. But that is all.

The key decisions on raising the ceiling on public debt and borrowing have to be reached by the end of February or government services will come to a standstill. An agreement on long-term budget savings has still to be sorted out. If there is no agreement, spending cuts of $1.2 trillion for the next 10 years would automatically come into operation under the terms of the Budget Control Act on March 1. The House voted to suspend the debt limit and allow continued borrowing until May.

US federal govt spending projections to 2020

The mini-deal reached will deliver a fiscal contraction of about 1.4% of GDP and produce a fiscal drag on demand of about 1% of GDP growth in 2013. So that is a sizeable pressure on US economic growth this year. But more needs to be done.

If 2012 tax rates and spending policies are left untouched, the federal government will have to borrow $7.9 trillion over the next 10 years. This would lead to US gross public debt reaching more than 120% of GDP by 2016 and surpassing that of Italy and even Greece by the end of this decade.

January’s mini-deal found just $650 billion over 10 years, about one-third of what’s needed. The minimum required, assuming that the forecast of nominal GDP growth is achieved (a big if, as the Congressional Budget Office projects a very optimistic nominal GDP growth rate of 6.5% up to 2017), would be another $2 trillion. That makes a total of $4 trillion, if we include savings already announced under last year’s budget.

This would stabilize the publicly held debt ratio at 73% of GDP by 2018. On a gross debt basis, the ratio would reach 114% of GDP before stabilizing. The US would then have a debt ratio that would match that of Ireland and Portugal and be not far short of Italy’s. So it would still be high.

Unless the new Congress can agree to substantial long-term measures, the credit agencies are likely to downgrade the triple-A status of US treasuries. And here is the problem. The Republicans were forced to concede some tax increases in the mini-deal, against everything they said beforehand. So they will likely oppose any further tax increases and will be looking for substantial cuts in spending as an alternative. The president will want the opposite. The mini-deal has made these positions more, not less entrenched.

The Republicans are also opposed to any further reductions in the defence and homeland security budgets. And the rest of the so-called discretionary spending items have already been cut to new lows. Indeed, under the Budget Control Act of 2011, caps were introduced on discretionary items that will reduce previous projections of spending over the next 10 years by $1.5 trillion.

So any measures to reduce spending growth would have to be focused on the mandatory entitlement programmes such as Medicare, Medicaid and social security. But these programmes are sacrosanct to the Democrats and are widely supported among the electorate.

So it won’t be easy to get an agreement to find savings to reduce the deficit sufficiently to stabilize federal debt to GDP. Some deal will eventually be struck, but it is unlikely to be one that can stabilize US public sector finances over the next 10 years.

Up to now, the Federal Reserve (through its quantitative easing programmes) and foreign investors (both private and official) have absorbed the bulk of net issuance of US treasuries. But the Fed appears to have increasing concerns about continuing its QE purchases beyond the end of this year and accumulating a balance sheet of $4 trillion-plus. So it might not be there to absorb future borrowing beyond then.

Foreigners might diversify into other bonds and private domestic demand might dry up. And with debt downgrades in the offing, US treasuries might not be a safe haven anymore. So US treasury yields might well start to rise during 2013.

David Roche is president of Independent Strategy Ltd, a London-based research firm.