Thursday, May 17, 2012

Approaching the 'Fiscal Cliff'

My comments in red:

Congress May Toss the Economy over the Fiscal Cliff
We are barreling towards the year end “fiscal cliff” Federal Reserve Board Chairman Ben Bernanke has warned about.

Unless lawmakers and the President can agree on a slew of confounding budget and tax issues before the end of the year, a double whammy of sharp tax increases and deep cuts in domestic and defense spending will jolt the struggling economy beginning in early January. That’s because two Bush era tax cuts and a raft of other tax relief measures are set to expire by the end of the year, and Congress must implement the first installment of $1.2 trillion of long-term deficit reduction that lawmakers and the White House agreed to last summer.

While an abrupt surge in tax revenues of about $500 billion, and a steep cut in government spending of about $110 billion early next year would certainly put a big dent in next year’s deficit, many budget experts fear it would also undercut the economic recovery in the short run. It would be extremely detrimental to the economy and would have no impact on solvency of the government budget.

Boehner said this week that Congress will be inviting a legislative “train wreck” if it leaves all these big- ticket fiscal issues to a lame duck session of Congress after the November presidential and congressional elections. He revealed plans to schedule a vote on the House floor before the fall election to extend the two Bush-era tax cuts that are very popular with his members. I'm not opposed to extending tax cuts, but I think extending the FICA tax cuts will be much more helpful to the economy and those who are in need then will extending cuts for those who are doing just fine.

“The House is going to act to extend the current tax rates,” Boehner said in an interview on CNBC. “Whether we make them permanent or extend them for a year – that debate is still up in the air. Otherwise we’re going to have this mess all stacked up until after the election,” he added. “And you want to talk about a train wreck? You’re really talking about a big one.”

House Republicans, of course, are free to vote on anything they choose, and voting to extend the two generous Bush tax breaks makes for good election year politics. But President Obama has repeatedly sought to deny the Bush-era tax benefits to wealthy Americans making more than $250,000 a year. I'm okay with rejecting the cuts for reasons of a more equal income distribution, but lowering the deficit will not be helpful to the economy.

Obama and Democratic Senate leaders have made it clear they would refuse to agree to extend even part of those tax cuts until the two parties agree on overall spending priorities more acceptable to their party and tax reform that would require millionaires to pay more in taxes.

The Republicans escalated that dispute on Thursday by pushing a plan through the House, 218 to 199 along party lines, to forestall automatic cuts or “sequestration” in defense spending by cutting funding for food stamps and other social programs and eliminating key pieces of the federal health care law. Democrats voiced outrage over the Republican action, which effectively repudiates the agreement Congress negotiated with Obama last summer to raise the debt ceiling. That agreement called for long term spending cuts to be divided equally between defense and domestic programs. Cutting spending to social programs is absurd in my view. We do not face a solvency problem and the economy isn't doing well. The gov't needs to issue more money into the economy, but in the name of deficit cutting, they will cut programs for the poor who are in much need of them. I don't mind defense cuts, but I am a pacifist and dropping spending won't help the economy. It is really just absurd to cut funding to programs that need it when what we should be doing is giving them more money.

House Budget Committee Chairman Paul Ryan, R-Wis., and other Republican leaders have reconsidered and now say it would be too dangerous to the nation’s security if the Pentagon lost $55 billion in funding in January. And they have ruled out raising taxes to help achieve any of the long-term deficit reduction that both sides have agreed to.

“They [Republicans] come down here and talk about how we have this big deficit and debt problem,” said Rep. Chris Van Hollen of Maryland, the ranking Democrat on the Budget Committee. “But they have signed a pledge that says they’re not going to ask for one penny of additional contribution from people making more than $1 million a year to help reduce our deficit. Not one penny.”

The measure approved yesterday, the Sequester Replacement Act, is certain to be sidelined when it reaches the Democratic-controlled Senate. Majority Leader Harry Reid, D-Nev., refuses to consider a replacement for the defense cuts until Republicans show willingness to consider mixing some new revenues with spending cuts.

Alice Rivlin, the former Congressional Budget Office director and Clinton White House budget chief, said recently, “We should be looking for a very big [tax] reform” -- one that produces a fairer tax system while generating more revenue for the government to address the long term deficit. “Every once in a while we get a big opportunity to solve a problem,” she said during a budget and tax conference in Washington last week, and now may be the time. Fairer tax system? Sure. But we don't need to raise revenue to address the long term deficit. It is such a myth that we have to raise funds to spend or that it will be a problem to pay back all our debt!

But that won’t be easy.

A new study by the Brookings Institution’s Hamilton Project warns that a daunting long-term deficit outlook, an increasingly competitive global economy, and rising income inequality will make it much tougher for Congress to overhaul the tax code this year than when it last reformed in 1986. I definitely agree overhauling the tax code will be extremely difficult and that perceptions of a debt or deficit crisis may make it more difficult, but daunting long-term deficit outlook is so misleading. We need more spending in the economy, and the private sector can't do it without piling on the debt. They did that in the build up to the financial crisis and are now deleveraging. The gov't needs to provide the net financial assets and the spending flows to boost the economy. If you want smaller government, that is fine, this isn't about size of government. But the deficit needs to be larger. Gov't debt needs to go up, but again this is a good thing, not a bad thing. The gov't is sovereign in its own currency, it can handle it.

The Fiscal Cliff Looms over Taxes and Spending
Just how the politically divided Congress and the Obama administration will muddle through the next six months is impossible to say, but their failure to come to grips with a raft of thorny spending and tax issues would pose hardships for millions of Americans reliant on government aid and possibly set back the economic recovery. It would.

At the close of 2012 and the dawning of 2013, many major fiscal events are set to occur simultaneously. It’s what Federal Reserve Board Chairman Ben Bernanke has called “a fiscal cliff” of spending and tax changes of a high magnitude. These include expiration of the Bush era tax cuts, the payroll tax cut and other important tax provisions. They also include the activation of the first installment of the $1.2 trillion across the board cuts or ‘sequester” of domestic and defense spending. And, once again, Congress may have to raise the debt ceiling. They likely will, but they should just get rid of the debt ceiling because it's a nonsense rule to begin with. They can't go bankrupt and have no constraint to borrowing or spending whatever they need as long as its denominated in dollars. Plus, all that debt is the private sector's net wealth.

If Congress and the White House decide to extend the Bush tax cuts along with scores of other tax breaks, that would increase the debt in 2022 by about $7.5 trillion above what it would be if the tax cuts were allowed to expire, according to the Committee for a Responsible Federal Government. This means the debt would rise from 70 percent of GDP today to 88 percent by 2022. Which isn't a problem if you understand basic accounting and modern money theory. In fact, it will likely help the economy.

Conversely, if those major tax cuts expire – a highly unlikely event – the Congressional Budget Office projected that the annual deficit would shrink from $1.1 trillion to $196 billion – an 82% reduction over the next six years.The resulting increase in tax revenues combined with spending cuts would nearly halve the deficit in 2013, lowering it to $585 billion. But that would contract the economy severely, lowering incomes and subsequently tax revenues, preventing a reduction in the deficit as Greece is finding out with their (forced) attempts at austerity.

The CBO calculated in January that if the tax cuts were extended, the economy in fiscal 2013 would be more than two percent larger than if the tax cuts were allowed to expire, while the unemployment rate would be one percent lower than otherwise. On the other hand, the CBO concluded that over the long run, a continuation of the tax cuts would slow the growth of the economy and add to unemployment because of the substantial debt accumulation. The CBO apparently doesn't understand basic accounting and fiscal currency sovereignty. U.S. debt accumulation will NOT cause slower growth, it adds to private sector wealth and is only a problem when the economy is a full capacity at which point we might begin to see inflation, which is then our cue to decrease our debt and deficit. Private sector debt is what we should look at, because too much of it is a problem! And as it turns out, more gov't debt helps the private sector reduce its debt.

Here is a summary of important elements of the ‘fiscal cliff’:

• Bush-era tax cuts: In 2001 and 2003, Congress approved major tax cuts proposed by President George W. Bush that significantly lowered the marginal tax rates for nearly all U.S. taxpayers. President Obama and the Democrats vowed to end the cuts for upper income households, but last December the president reached agreement with congressional Republicans to extend the cuts at all income levels through the end of 2012 as part of a larger economic package. Should these tax cuts expire, the top rate will rise from 35 percent to 39.6 percent and other rates will rise in similar fashion.

The child tax credit will be cut in half and no longer be refundable. The estate tax will return to what it was in 2001, with a $1 million exemption and a 55 percent top rate. Capital gains will be taxed at a top rate of 20 percent and dividends will be taxed as ordinary income. An additional 3.8 percent tax will be levied on all financial transactions as part of the president’s health care reform bill. Finally, marriage penalties will increase, and various tax benefits for education, retirement savings, and low-income individuals will disappear.

• Payroll Tax Cut: Last February, Congress approved legislation again extending the payroll tax cut to help boost the economic recovery, with the understanding it would lapse by the end of the year. About 160 million workers are benefiting from the 2 percentage point reduction in the normal 6.2 percent payroll tax rate.

• AMT Patches: Congress generally “patches” the Alternative Minimum Tax (AMT) every year to help it keep pace with inflation. As a result, just over four million tax filers currently pay the AMT, which was originally aimed at wealthy Americans. But over the years has affected many middle to upper middle income taxpayers. If a new patch is not enacted retroactively for 2012, that number will increase to above 30 million for that year and would exceed 40 million by the end of the decade.

• Tax Extenders: A raft of short-term tax breaks routinely reauthorized by Congress -- such as the research and development tax credit and the state and local sales tax deduction – will expired at the end of 2011. Congress must decide which, if any, to renew retroactively.

• Debt Ceiling: Last summer’s political battle between the White House and congressional Republicans over raising the debt ceiling almost triggered the first default on U.S. debt in history. A last minute agreement allowed a gradual $2.1 trillion increase in the country’s legal borrowing limit, which currently stands at $16.4 trillion. The Treasury could run out of borrowing authority again before the end of the year.

• Transportation and Infrastructure Spending: With the highway and bridge construction season well along, the House and Senate still can’t agree on a new two-year transportation and infrastructure spending bill. Senate Democrats and Republicans got their act together and approved a $109 billion reauthorization bill, but House Republicans are sorely divided over how to pay for the bill. State and local officials and contractors have had to stumble along under a series of temporary measures.

Fed Worries 'Fiscal Cliff is as big a threat as Europe
Federal Reserve officials are increasingly concerned about the coming “fiscal cliff,” putting it on par with the European financial crisis and the housing market as among the biggest potential threats for the U.S. economy. It is a very serious threat.

And there appears to be a debate about what the Fed could or should do to counter the negative effects of the coming decline in federal spending and tax hikes.

At the heart of that debate is frustration within the central bank that Congress and the administration are relying too heavily on monetary policy to kick start the economy and keep the recovery going. We are relying too much on monetary policy and it won't work. QE1 and QE2 did nothing for the economy because the theory it was based on is just bad.

Chicago Fed President Charles Evans, in remarks last week, noted that fiscal stimulus is already wearing off.

“The cliff at the end of this year is just that writ large. Whether or not calmer heads will prevail and avoid this or do something useful, you know that's about as big an uncertainty as I can imagine anybody facing,” Evans said at the Milken Conference.

The August debt ceiling debacle is fresh in the Fed’s mind, with Fed Chairman Ben Bernanke several times saying that threat of a default by the U.S. government created entirely avoidable market fears and economic weakness. He's right.

That’s why Atlanta Fed President Dennis Lockhart, also at last week’s Milken conference, refused to label the fiscal cliff “an economic shock.” Instead, he called it “perfectly predictable” and threw the onus for solving it on the fiscal authorities.

“Congress and the administration understand that the perception is growing that if a transition isn't engineered that works well, that you're going to end up with a lot of mojo taken out of the economy in a very brief period of time,” he said. I hope they understand this and do what is necessary to grow the economy, but I'm not seeing it, because all they talk about is cutting the deficit.

Lockhart wouldn't rule out using Fed policy to counteract the effects of a decline in government spending, but it clearly wasn’t his first choice. Evans, among the leading voices on the Fed for more stimulus, said it was another reason the Fed should ease. Fed policy won't help.

But Fed Chairman Bernanke warned at his press conference two weeks ago that the size of the fiscal cliff is so large that “I think (there’s) absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy. So as I have said many times before, it’s imperative for Congress to give us a fiscal policy.” He's right.

Even if the Fed could partially offset the weakness, there seems to be little appetite by some members of the rate-setting Federal Open Market Committee to do so. Richmond Fed President Jeff Lacker, one of the Fed’s hawks, is actually in agreement with Bernanke that too much reliance has been placed on Fed policy to stimulate the economy.

Last week he noted, “The impediments to growth that I have discussed today are all quite real. That is, they are factors for which monetary policy is not the remedy. Monetary policy will not occupy vacant homes or give unemployed workers the skills to fill vacant jobs or reduce regulatory and fiscal uncertainty.” Very true! Though it's not a matter of lack of skills for lack of jobs, it is a matter of lack of demand.

Bernanke is in a complicated negotiating position relative to Congress. On the one hand, he is not as extreme as Lacker in ruling out further quantitative easing. In fact, he’s been pretty clear that the Fed would act if the economy weakens. On the other hand, what if that weakness comes from fiscal policy? Assuring markets that the Fed would act could also take the heat off of Congress to deal with the fiscal situation. But acting won't really help. They'd have to directly spend money, which I'm not sure they've ever done. They basically just keep giving banks reserves which don't do anything for the economy.

The “fiscal cliff” is shorthand for a series of stimulus programs and tax cuts that will expire toward the end of the year. It includes the planned wind down of extended unemployment benefits, the expiration of the Bush tax cuts and payroll tax cuts and the beginning of sequestration — the automatic spending cuts that take effect as a result of last year’s 11th hour budget deal. In total, it could mean up to a $500 billion hit to the economy.

Wall Street economists are divided over how real the threat is. Some believe politicians will work out a deal to keep federal spending from falling over a cliff as they have in the past; others worry the decline in spending could undermine confidence and cause the private sector to pullback as it did in August. It would cause a terrible decline in overall spending and growth.

There are splits as well along political lines with one side arguing that the government needs to start someplace to reduce its trillion-dollar annual deficits and shouldn’t keep putting off the day of deficit reckoning. This group also argues that a large part of economic weakness stems from uncertainty over how and when the deficit will be reduced and from government spending crowding out the private sector. They keep thinking the gov't is like a household that has to pay its debts and is revenue constrained. The gov't can issue however much it needs to pay its obligations. 'Deficit reckoning' is sheer nonsense.

From the other side, liberal economists contend that the initial stimulus spending by the government was never sufficient to kick start the economy and that the government can and should keep running high deficits to prop up the economy until the private sector takes the reins. Yes! The best policy would be to directly hire labor: An argument for Full Employment.

The Fed and Bernanke have waded only gently into that argument, urging Congress to put in place a long-term deficit reduction plan, but be careful not to hobble the economy with Draconian near-term cuts. Bernanke, however, has not been shy about letting his frustration be known over what happened in August.

But there’s only so far that the Fed will go publicly. It even drew criticism when it involved itself in the housing debate. Some politicians saw a paper the Fed published with a series of actions the government could take to fix housing as inappropriate meddling in fiscal affairs.

It’s not hard to imagine that the Fed would likely be concerned over temporary fixes that pushed the can down the road, avoiding the immediate threat but adding to uncertainty. Just get rid of the ceiling, and end the threat.

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