There is a moment in Homer’s Odyssey when Odysseus—now reduced to only one ship and crew—is compelled to travel through a very narrow strait. (According to tradition, this was the Strait of Messina between Sicily and Italy.) Odysseus knows that he must avoid the deadly dangers lurking on both sides. On one side is the he-monster Scylla, with six long necks and heads full of sharp teeth. On the other side is the she-monster Charybdis, a gigantic whirlpool that can swallow the largest sailing ship.
In Homer’s account, Odysseus pretty much fails. After Scylla plucks many of his best crewmen off the deck of his ship and eats them, Charybdis later swallows the rest of the crew and his entire ship. Odysseus alone barely escapes with his life.
Now here is my question: As the U.S. economy negotiates its upcoming fiscal gauntlet, will America fare any better than the trickster from Ithaca?
Let me explain. Most political, economic, and financial policy experts are today expressing growing alarm at the prospect of the “fiscal cliff” or “taxmageddon” that looms on January 1, 2013, less than two months after the November election.
In part, this timing is the accidental result of the expiration date chosen when the original “Bush tax cuts” were enacted in 2001 and 2003. That date—January 1, 2011—was extended by two years in 2010 as part of the Obama stimulus package. So the date is now January 1, 2013. (We really should call it, in the spirit of bipartisan amity, the “Bush-Obama tax cuts.”)
Yet the date is also the deliberate result of the bipartisan deal both parties struck last August in order to avoid a political and constitutional crisis over the federal debt ceiling. Like so many other drunkards and addicts, Congress and White House decided at that time (for approximately the 20th time over the last 40 years) that no, we can’t start cutting our deficit right now, but we will 15 months from now, on January 1, 2013. And this time we really really mean it.
So what, exactly, did they really really mean? On the revenue side, they meant the expiration of the 2-percent FICA tax cuts, an end to the indexing of the AMT (Alternative Minimum Tax), and several other minor tax hikes. All this comes on top of the expiration of the Bush-Obama cuts. On the outlay side, they meant a long list of spending cuts—most of all, an end to emergency Unemployment Insurance, large reductions in Medicare’s rate of reimbursements to doctors, and a large cross-the-board “sequestration” (percentage chop) of discretionary outlays (mostly for the military but also for infrastructure, colleges, police, and a thousand other things that are supposed to hurt).
Well, guess what, the 15 months are almost up, and the macroeconomic conditions for those big deficit cuts don’t look any better now than they did back then. If Congress does nothing and lets all of the planned deficit cutting happen after January 1, CBO expects that in 2013 (actually, in the just last nine months of fiscal year 2013) total federal revenues will rise by 2.9 percent of GDP and outlays will fall by 0.9 percent. That’s a massive one-year fiscal drag of 3.8 percent of GDP, over half a trillion dollars, which is easily enough, says the head of the CBO, Fed Chairman Ben Bernanke, and most other sentient economists, to throw our economy back into a recession in 2013 if we aren’t there already by then anyway. Over the subsequent two years (2014-2015), current law dictates a further deficit shrinkage of 2.4 percent of GDP.
Here is the latest CBO projection, assuming we make no changes in current law and “go over the cliff”:
As you can see, the “cliff” takes us from a deficit of -7.6 to -1.5 of GDP in just three years. By 2017, revenue would rise to the highest-ever share of peacetime GDP. By 2020, discretionary spending would sink to near post-World War II lows. Fiscal tightening would be extreme while (presumably) monetary policy would keep interest rates at near-zero. It would be the complete opposite of the early Reagan years. Though the CBO economists do say that this scenario will throw us into a recession in the first half of 2013, they hate to be bad news bears and promise that we will pull out of it in the last two quarters. Obviously, the recession could be much worse.
This is Scylla. Bottom line: If are not yet in recession by late 2012, the upcoming fiscal cliff—by suddenly removing hundreds of billions from aggregate demand—will throw us into a recession.
Now maybe you say, damn the torpedoes, let’s reduce the deficit even at the cost of a recession. Great spirit. I sympathize and admire your gusto. But before you commit yourself, go back to your Macro 101 (that dog-eared chapter on Keynes) where you learned that, in a severe recession, falling GDP can itself increase the deficit as fast as your fiscal cuts reduce it. You end up with lower production, lower incomes, higher unemployment, more poverty—and government borrowing nearly as big as it would have been without your austerity policies.
Want me to be dramatic? Consider that cutting aggregate demand by 6 percentage points of GDP over three years is tantamount to raising oil prices to roughly $350 per barrel. Now, for extra excitement, imagine that a slowdown in China or a meltdown of the Eurozone has already put us in a serious new recession. Or maybe Bibi says time’s up to Mahmoud and hits Iran—and global oil prices really do hit $350. In addition to everything else.
OK, by now you may be thinking, Scylla sounds really awful. Let’s do anything to avoid that bad boy. Let’s just pull the rudder way to the other side. If so, you’ve got plenty of company: Most of the American public, who don’t want to pay higher taxes next year, and a whole slew of industries who pay for K-Street lobbyist, from major defense contractors and American Medical Association to professors and builders and growers and truckers. They’re all pointing to the people who will have to be fired if the fiscal cuts go through, many of whom won’t be able to get another job soon.
In short, there are plenty of plausible reasons why Democrats and Republicans in Washington may overcome their partisan gridlock and agree to “undo” the fiscal cliff—and defer budget balancing to another day. So let’s assume that’s what happens: We extend the Bush-Obama tax cuts, we put off the SMI physician-rate cuts, we cancel the defense cuts, etc., etc. So what happens then?
Well, thanks to CBO’s latest annual edition of its Long-Term Budget Outlook (2012), issued just a few days ago, we have a pretty good idea of what happens then. The CBO runs two scenarios. The first is its “extended baseline scenario,” which assumes that current law is not changed and that the fiscal cliff happens pretty much as scheduled. (That’s the scenario I’ve been quoting above.) The second is its “extended alternative fiscal scenario,” which assumes that most of the cliff is dismantled exactly as we have been discussing.
This alternative scenario is by no means a stimulus scenario. It still projects some fiscal tightening: Taxes will still rise and outlays will still decline; and the deficit is still projected to shrink—by 1.4 percent of GDP in 2013 and by another 1.3 percent by 2015. Even in this scenario (with the Bush-Obama tax cuts extended), federal revenue as a share of GDP in 2016 climbs back over its historical average for the past 40 years.
Yet look at what also happens under this scenario to net federal debt held by outside creditors (“net” means we don’t include one federal agency owing another federal agency—like the Social Security trust fund debt). Because deficits remain large, this debt steadily grows. By 2021, nine years from now, the net federal debt exceeds 90 percent, which economists Carmen Reinhart and Kenneth Rogoff (in their articles and their book This Time It’s Different) say marks a sort of danger zone in which GDP growth slows sharply and debt default is common. Historically, the United States has exceeded 90 percent in only three years: 1945, 1946, and 1947. By 2026, 14 years from now, the net federal debt under this scenario hits a level having no precedent, even in World War II, and is by now racing steeply upwards.
You are now looking at Charybdis, the whirlpool that sucks us under. Like the whirlpool of Homer’s legend, it kills us after we escape Scylla, but it kills us just the same. Yet here’s what’s really scary. Even this scenario may be contractionary enough to trigger (or worsen) a 2012-13 recession. In which case—like Odysseus—we get may hit by both the hydra and the vortex.
There is no reason to be overly pessimistic about the outlook. While the window of opportunity for the U.S. economy is lot narrower than it was a decade ago, it is by no means shut. We do need to avoid bad luck: If the U.S. economy is hit by a big shock from abroad (major Euro-zone exit, crash in China, war in the Mideast) or experiences a sudden surge in interest rates (driven by inflation expectations or declining global confidence in the U.S. Treasury), then there may be no happy “middle” outcome no matter what we do. And even if we avoid bad luck, our fiscal navigation will require shrewd timing and trusted leadership. Clearly, much of next year’s “cliff” has to be removed to avoid Scylla—but at the same time, a graduated fiscal tightening in the out-years must be implemented that will get us around Charybdis. Yet would today’s public trust a fiscal promise to tighten in the out-years?
Sure, it’s possible. But frankly, I don’t think it’s probable. Not with America’s current generational line-up, in which so many zero-sum Boomer ideologues remain in power, too few Gen-Xers have yet stepped up into positions of political leadership, and Millennial engagement in national politics remains episodic and unfocused. But I’ll discuss the politics—as opposed to the economics—of the fiscal cliff in another post.
Let me just return to just one central question that may lurk in the minds of many readers: How did we get into this mess? Why is the fiscal arithmetic so unforgiving now, when it didn’t used to be this way? I can point to two main reasons, both of which have major generational implications.
Reason number one. Our economy has entered an extended era of painful deleveraging—a long bust, if you will, following a long boom–something America has not really experienced on anywhere near this scale since the 1930s. Such eras are characterized by sagging employment, production, equity prices, and confidence; by deflationary pressure; and by large declines in tax revenue at just the time when government is called upon the spend more. Very large deficits are the result. The G.I. and Silent Generations mostly cashed out their homes and financial assets before the bust hit—and probably don’t have to worry much about benefit cuts. Boomers and Gen-Xers, on the other hand, have been hit by far the hardest by the recent crash and recession (see recent blog post)—and probably should worry (or simply expect) that impending budget austerity will raise their tax and cut their benefits as well. As for Millennials and Homelanders, we may be setting them up, eventually, to buy into an economy with low valuations and enjoy growing prosperity thereafter.
Reason number two. Benefits to Americans age 65+ keep rising as a share of GDP–thanks to the insane design of public health-care programs; to the elevated benefit levels we now think seniors deserve; plus, looking forward, to the daunting demographics of the Boom Generation. Eventually, this means that senior spending crowds everything out of the budget. Consider this: Back in fiscal year 1962, total federal health spending plus Social Security amounted to 2.8 percent of GDP; by 1972, 4.4 percent; by 1982, 6.8 percent. Now look at the tables I’ve presented above. In 2012, the number is 10.4 percent. By 2022, according to the scenario in which Medicare reimbursement is not cut–I don’t think these cuts will ever happen—the number will be 12.6.
Now contemplate these numbers for a second. (Yes, I know, some federal health-care spending doesn’t go to seniors, but then again we’re not counting lots of benefits, like SSI and nutrition and federal pensions, that do; let’s accept this as a rough proxy.) So here we are—going from 2.8 percent of GDP in 1962 to 12.6 percent in 2022. Let’s also keep in mind that federal revenues have averaged 18.0 percent of GDP over the past 40 years. And let’s say that, at a minimum over the last 40 years, 1.5 percent of GDP needs to be allocated to the payment of interest. Conclusion? Back in 1962, the federal government could spend 13.7 percent of GDP on things other than transfer payments to seniors and creditors—and still not exceed a typical year’s revenues. By 2022, the feds will only be able to spend 3.9 percent of GDP on things other than transfer payments to seniors and creditors—and still not exceed a typical year’s revenues.
These tawdry numbers may clarify a lot.
For example, you might have wondered how, back in the 1960s, America’s federal government was able to pay for massive infrastructure investments (dams, bridges, harbors, parks, interstates, subsidies to colleges), plus the “Great Society” (including LBJ’s “war on poverty”), plus a stupendous Apollo project to put a man on the moon (using absurdly primitive IT)—yet also pay for a gargantuan defense establishment (did I mention the building of ICBMs, MRVs, and millions of G.I.s fighting in Vietnam?), which was roughly twice the size of today’s military as a share of GDP. And we did it without running a deficit!
Today, by contrast, the federal government invests little, builds less, and repairs only when it has no other option. It charges user fees where it can, has frozen the size of the civil service, and vigorously shuns any of the ambitious agendas we once embraced–such as employing the poor, educating the young, or sending humankind to new planets. (Today, indeed, NASA is an endangered agency.) As for defense, our policy makers are budgeting for the age of cruise-missile and predator diplomacy. In 2012, the military spends (at 4.6 percent of GDP) less than half of what it spent in the mid-1960s—and by 2015 the OMB expects it to spend (3.1 percent of GDP) only a third.
Yet even so, the federal government is today projected to run large deficits as far as the eye can see.
OK, this post is too long already. Time to close down. Two posts to come I promise: One on the generational politics of the fiscal cliff; and the other on different ways of looking at the federal budget.