Reapproaching the Fiscal Cliff

In the wake of the election, Washington seems likely to steer clear of the worst of the spending cuts and tax hikes.

Milton Ezrati of Lord AbbettNow that the political lines for the next couple of years are clear, the so-called fiscal cliff stands first on the agenda for President Obama and the existing Congress. The matter is urgent. Unless something is done between now and year-end, some $660 billion in automatic spending cuts and tax hikes will almost certainly toss the economy into recession.

Avoiding it probably would have been easier with a Romney victory. By giving Congress an excuse to wait for the new administration to work out its budget, Romney would have offered both sides of the aisle a way to sidestep this difficult issue. But with Obama’s reelection, the effort to avoid the cliff now requires hard negotiations. The next few weeks doubtless will see a lot of give-and-take and even with the initial spirit of compromise, recriminations, too. Because neither side can concede until the last minute, it’s likely that little will become clear until late December.  But it’s nonetheless likely that in the end, Washington will steer clear of the cliff, or most of it, offering a kind of last-minute holiday gift to the economy and markets.

Two other aspects of the cliff—the end of extended unemployment benefits and the end of the partial payroll-tax holiday—will see some tough negotiations. Should Congress fail, these would amount to $162 billion in fiscal restraint. To be sure, the sides today seem far apart. Democrats want to continue both, in line with their earlier statements. Republicans want to end them. Much of the handicapping in Washington now suggests that Democrats will prevail, which would relieve this aspect of the cliff entirely. A compromise, already raised from both sides of the aisle, might allow for a gradual adjustment back to the original law. If that occurs over a year, the economy will avoid half this fiscal restraint in 2013 and if the adjustment is set to take longer, the economy will avoid still more next year. On this basis, a conservative calculation would indicate relief of at least another $81 billion or a reduction of 12.3%, and possibly more, in the cliff’s size.

If the Gang of Eight prevails, the economy will avoid all the spending cuts involved in sequestration. That would amount to about $90 billion, mostly in defense, or 13.6% of the cliff. But even if this particular approach fails, Congress still has other ways to relieve much of the strain. After all, the sequestration does not change the budgeted amount but only blocks the spending of what has already been appropriated. Given the precarious state of the economy and the clear desire in Washington to steer away from the cliff, it  seems likely that even without Gang of Eight action on the deficit, lawmakers will find a way to spare the economy this restraint or delay it to later quarters or perhaps even to 2014.

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