Fiscal policy has moved off the front pages. That’s both good and bad news. The good news is a growing confidence that the next round of fiscal cliffs will be navigated without disruption to the economy. The bad news is a rising pessimism about the prospect for a fiscal grand bargain that addresses the long-term drivers of our deficit. Several factors appear to be at play:
1. A better economic backdrop. The deficit has fallen faster than expected, from 10.1 of GDP in fiscal year 2009 to 4 percent or lower this year. On current policies, it will continue to fall to around 2 percent of GDP in 2015 before it begins to rise again. Meanwhile, despite nearly 2 percent of GDP in fiscal drag this year, the U.S. economy has proven resilient and looks on track for growth of around 2 1/2 to 3 percent in the second half of the year. Together, the sense of near-term economic crisis has receded, and with it the urgency to act.
2. Low hanging fruit is gone. Past cliffs have resulted in roughly $3.9 trillion in deficit reduction (or $2.7 trillion without sequestration), meaning any deal is smaller and focused on the hardest issues. Further, given the high political costs for Democrats to agree to any entitlement reform and for Republicans to agree to any revenue increases, the prospect of a politically winning compromise looks more distant. When both sides have “fixed costs” to any compromise on their red lines, a small deal becomes harder than a big one. Looking to the fall, some of the ideas for dealing with the debt limit involve small deals–such as initial steps toward entitlement reform such as indexing entitlements (chain-weighted CPI) or new revenue. Even revenue-neutral corporate tax reform takes a bargaining chip off the table that might be needed for any future grand bargain (the odds of tax reform also appear to befalling).
3. Sequester biting? The Congress has effectively played ‘whack-a-mole’, addressing the most visible disruptions associated with the sequester (air traffic controllers, food safety) and taking the steam out of efforts for a bigger fix. Agencies and government suppliers appear to be smoothing the effects on budgets, and furloughs are only now coming into effect and dislocations should increase in the second half of the year. While budget discussions suggest a majority of legislators would like to see the caps eased, my earlier prediction that sequester disruptions would be politically unviable looks wrong, or at least delayed.
4. Medical costs. Medical costs are rising more slowly than expected. Whether this reflects a “bending of the curve” that proponents of health care reform argue, or temporary market considerations remains debated. But the political implications were on clear display last week, when a small revision in the date when the Medicare Hospital Insurance Trust Fund would run out of money (from 2024 to 2026) caused some to question the need for reform.
5. Debt limit fatigue. Treasury Secretary Jack Lew’s statement that he would use the “standard set of extraordinary measures” makes it clear that going to the edge of the cliff has become the norm. With smaller deficits, the debt limit will not become binding until October or November. At the same time, it appears that only a handful of House Republicans are willing to risk default to gain leverage on spending.
None of this eliminates the case for a grand bargain that would balance the need for additional longer-term fiscal consolidation with agreement to ease up on fiscal consolidation in the longer term. Larry Summers reminds us that austerity is particularly painful in current conditions and that we have high-return investments that we can make today. But increased spending on infrastructure or education will only be feasible if we can reach consensus on a longer-term path to fiscal sobriety and an enforcement mechanism that is credible with the deficit hawks.
What happens next? Current efforts to negotiate a joint Senate-House budget resolution are being blocked by a few Senators worried about a link to the debt limit (notwithstanding that the debt limit can’t be extended through budget resolution) and is likley to fail. It seems increasingly likely that the FY14 budget, needed by end-September, will be funded through a short-term continuing resolution (CR or CR included in a “mini-bus” appropriations package), perhaps through the end of the year (such delays are common). Then, there could be agreement on spending levels in excess of the caps, with the main beneficiary defense spending, but its also quite likely that the failure to agree would lead to a new round of sequester cuts at the start of next year. The debt limit will be extended. There will not be a grand bargain or agreement on corporate tax reform. Still, as of now there is no clear strategy for how we navigate the series of new cliffs facing us this fall, and it’s easy to imagine a down-to-the-wire negotiation at end year. The timeline suggests that the forth quarter of 2013 will be very noisy.
Enjoy the summer.
This piece is cross-posted from Macro and Markets with permission.