Fiscal Cliffnotes: The Crisis in a Nutshell

With the election over, politicians in Washington are scrambling to avoid the “fiscal cliff”.

So what is this ominous-sounding escarpment?

Because the Republicans and Democrats were unable to agree on reducing the deficit, they passed the Budget Control Act in August 2011. This provided for automatic spending cuts if budget negotiations by a “super-committee”  failed. The negotiations did fail, so now Congress and the President have to find a new solution or else those increases and decreases will kick in beginning in January.

At the same time, “temporary” tax cuts passed by earlier Congresses are due to expire at the end of 2012 as well.

The fiscal cliff will effectively cut federal government spending by about $70 billion in 2013 and by $150 billion in 2014, increasing to nearly $500 billion in 2022. At the same time, taxes will increase by more than $300 billion in 2013 and by more than $380 in 2014, increasing to nearly $700 billion more in 2022. Together, these will decrease the deficit by more than $1 trillion in 2022.

So why is decreasing the deficit such a bad thing?

It’s not a matter of just decreasing the deficit. It’s how the fiscal cliff would do it: suddenly and indiscriminately.

According to the nonpartisan Congressional Budget Office, the fiscal cliff will drive the U.S. economy into another recession next year, and increase the unemployment rate from its current 7.9 percent to 9.1 percent by the end of 2013. Also, GDP will drop by 0.5 percent in 2013.

As Forbes points out,

The cuts hit all areas of the federal budget, including a $55 billion reduction to the Pentagon’s budget in 2013, a reduction of payments to physicians participating in Medicare, substantial cuts to FEMA and the Dept. of Education budget along with a host of serious reductions across the wide ranging operations of the federal government.

And let’s not even talk about the horror of those huge tax increases hitting in the midst of this fragile recovery.

Congress passed this plan never intending it to actually go into effect. It was supposed to be so horrible that both Democrats and Republicans would do anything in order to avoid it, forcing everyone to compromise. As of yet, that hasn’t worked, and time’s running out.

***

The bets are that the fiscal cliff still will be avoided one way or another. The most likely outcome is a cop-out compromise that kicks the problem further down the road. Perhaps some spending cuts and a few revenue increases that make no one happy but attempt to show goodwill on each side’s part.

Both Democrats and Republicans are posturing heavily, putting on their game faces in hopes of cowing the other side into compromise. President Obama has announced that he won’t accept any agreement that doesn’t include tax increases on the wealthiest Americans. Meanwhile, as of late 2011, 238 of the 242 Republicans in the House of Representatives and 41 out of the 47 Republicans in the Senate had signed agreements to “oppose any and all efforts to increase the marginal income tax rate for individuals and business”.

Some see President Obama as having an upper hand, given his recent election victory and the pickup of 2 seats in the Senate. However, this is hardly a solid mandate by any historical standards. Yet Republicans have a lot to lose if defense and other funding is cut dramatically. It’s also been suggested that President Obama has little choice but to play hardball in negotiations, or else he’ll be paying for any signs of weakness through the next four years.

***

A big part of the equation, as with all budget impasses, is which side would be able to paint the other as the real obstructionists. The bottom line is that no one really wants this impending fiscal cliff, and everyone has an incentive to want to avert it. But depending on the political and interpersonal dynamics, it’s still possible.

No one’s questioning the need to reduce the deficit eventually. No government can continue to borrow an increasing amount at an increasing rate indefinitely. The real issue is how best to do it. As with everything in economics, there are trade-offs, and people with different values have different view about which trade-offs are worth it.

At the end of the day, all we can do is hope that our politicians can rise above politics to find a solution – and contact them regularly to tell them we want them to do so.

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