The Fiscal Cliff Dilema

In the US, the biggest concern in politics is the looming fiscal cliff. If you are not aware of what this is, I will explain. During previous budgetary battles, a deal was struck that allowed the borrowing limit to be increased as long as the joint committee on debt reduction agreed on $1.2 trillion in budget cuts. If it did not, automatic spending cuts split between domestic and defense spending would take place. This committee failed to reach a consensus, so automatic cuts will happen in January. On top of this, January will see the expiration of the bush tax cuts as well as the imposition of the new Affordable Care Act tax increases. The combination will be a large increase on taxes across the income spectrum and a decent sized budget reduction. Or instant austerity (as the Europeans have been using the term) in the US.

This is a problem for the US because, ever since the so called "Great Recession" of 2007 and 2008, the US has been suffering under tepid growth and high unemployment. It is widely believed that the higher taxes and shrinking federal expenditures will combine to shrink economic output enough to throw the country back into recession. This is similar to the problem that Europe has been dealing with recently (though the causes of each of these problems are different), i.e. that budget cuts and tax increases have pushed the whole region (even areas not imposing austerity measures) into recession. This possible recession has global implications as the developing world, one of the few bright spots in economic growth, is heavily dependent on US and European consumption. With Europe and the US in recession the developing world is likely to follow.

So this brings us back to the problem at hand. What can be done to avert this likely catastrophe? Currently, Obama and the Democrats have refused any compromise that does not involve tax increases and Grover Norquist and the Republicans are standing by their no tax increases pledge. With the legislature divided between the parties (with the Senate controlled by Democrats and the House controlled by Republicans) there is a distinct chance that no compromise is possible. Worse, there are strategists on both sides of the debate who believe that compromise is not even desirable. Democrats thinks that going over the cliff will give them the higher taxes they want with the ability to blame Republicans for the budget cuts, Republicans that going over the cliff will prove they mean it when they say they will fight to shrink government and keep tax rates low.

Neither of these positions is likely to be true. Worse, the market turmoil such political wrangling will cause will result in many of the negative economic outcomes listed above simply due to people hedging their finances against uncertainty (i.e. assuming the worst and cutting consumption regardless of the final political outcome). Worse still, Republicans and Democrats will each share the blame for the political failures resulting in a repeat of the 2010 mid term elections where incumbents from both parties were voted out of office by the electorate. While I am not opposed to throwing out the bums in congress, I am not comfortable with the damage this brinksmanship will cause to the global economy.

The solution is that both sides are going to have to suck it up and work on creating consensus. That means that the Democrats will have to accept that they will not be able to further raise tax rates and Republicans that they will have to be willing to allow net tax revenue to increase somewhat by extinguishing tax loopholes or capping write-offs. Otherwise, the consequences to the global economy could be dire.