Fiscal collisions ahead

Reuters

US President Barack Obama delivers remarks next to Vice President Joe Biden (L) after the House of Representatives acted on legislation intended to avoid the "fiscal cliff," at the White House in Washington January 1, 2013.

Article Highlights

  • Not lifting the debt ceiling in particular would be expected to have catastrophic economic effects.

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  • A shutdown of nonessential government operations on Oct. 1 would retard the recovery.

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  • Mr. Obama has failed to prepare the American people for the difficult decisions he will leave his sucessors.

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Even as serious decisions loom regarding Syria, Congress and President Obama still must deal with two related fiscal policy issues:  raising the debt ceiling before the government’s borrowing authority runs out around mid-October, and funding government operations beyond the end of the fiscal year on Sept. 30. Democrats and Republicans are on collision courses on both matters. Republicans (the pragmatic ones, at least) seek further spending cuts to address the still-wide fiscal deficit, while the president is focused instead on reversing the cuts set to take hold through the sequester mechanism he signed into law as part of the Budget Control Act of 2011. The focus on Syria means that fiscal decisions could be put off for a short period. Even that, however, would require compromise that might prove challenging, such as agreement by the president to accept the continued sequester and by Republicans to raise the debt ceiling without accompanying spending cuts.

A failure to act would harm the economy.  Not lifting the debt ceiling in particular would be expected to have catastrophic economic effects.  Interest rates could skyrocket if investors question the full faith and credit of the United States government, leading to a credit crunch that pummels business and consumer spending.  The calamity might be avoided if the Treasury Department makes payments to bondholders to avoid a default, but even with this contingency plan (which the Treasury shows no sign of putting into place), the spectacle of a government that cannot finance its routine operations would doubtless translate into a severe negative impact on private confidence and spending.

A shutdown of nonessential government operations on Oct. 1 would mean an unintended reduction in spending that could retard the recovery, but the larger consequence again would be indirect through a hit to confidence. With the government unable to attend to routine matters, it does not take much to imagine that American families and companies would halt plans to spend, invest and hire. This would repeat the natural instinct that contributed to the plunge in economic activity in the fall of 2008.

Fiscal uncertainty matters for monetary policy as well, because the Federal Reserve will hesitate to start unwinding its expansionary policy if a serious fiscal drag seems imminent.

Administration officials like Treasury Secretary Jacob Lew have stated that they will not negotiate on raising the debt limit, which is something of a red herring when Mr. Lew will routinely engage in discussions on funding bills with members of the House and Senate, and it would be natural to expect the two issues of the debt ceiling and government funding to be resolved together. Even so, for now the administration is not putting forward a new proposal.

Such a hardball approach worked for the president in resolving the fiscal cliff in late 2012, when Republicans were forced to accede to allowing tax increases for upper-income households even as most of the Bush-Obama tax cuts from 2001, 2003 and 2010 were made permanent. But the “no negotiation” tack worked less well during the sequester fight two months later, as a deal was not reached to avoid broad spending cuts. The administration’s warnings of calamitous impacts from the sequester for teachers, preschool children and homebound seniors do not appear to have had the intended political impact in pressuring Republicans to reverse their position on spending, perhaps because the labor market and the overall economy improved in the first half of 2013 despite the government cuts.

Another approach by the administration in looking for political leverage is to warn that failing to lift the debt ceiling puts the incomes of the elderly at risk. The White House has asserted that the Treasury might be forced to put payments to bondholders ahead of Social Security recipients, for instance. This talking point is actually not correct. Hitting the debt ceiling would force difficult decisions over which bills to pay first, but Social Security payments could be made regardless. This is because redeeming the Treasury securities in the Social Security Trust Fund would actually create more room against the debt ceiling – this is all government accounting, but in this case it goes in the favor of Social Security checks.  Still, it is revealing of the political stakes that the White House is making this claim.

Both sides in the political tussle actually have substantive arguments on the economics — but only on half of the issue per side. President Obama has a reasonable point in looking to avoid fiscal retrenchment while the economy remains in a lackluster recovery and operating below potential. This includes both averting the sequester-related spending cuts and even increasing spending on initiatives like infrastructure that have the potential for a high social return.  I wish the administration would focus more carefully on value-for-money rather than burning taxpayer money on wasteful projects such as high-speed rail and subsidies for green jobs that do not materialize.  But there is a good argument to be made for avoiding near-term austerity.

At the same time, Republicans rightly point to the need to tackle the deficit over time. The improvement in the budget outlook for this year and the next several has empowered the fiscal “ostrich caucus,” but does not change the reality of a “severe long-run fiscal imbalance.” President Obama has spoken about the need to take on the long-term fiscal challenge. But this requires making difficult choices to address the funding gaps in Social Security and Medicare, and on this Mr. Obama has flinched, setting aside the recommendations of his own Bowles-Simpson fiscal commission and instead putting forward only modest entitlement reform proposals — enough for a talking point but by far not addressing the imbalances. Indeed, in his 2013 State of the Union address, Mr. Obama spoke merely of “the need for modest reforms” in Medicare, when the decisions will be wrenching, not modest, since ultimately they will involve how to allocate health care resources for people in the final year of life when costs, ethics and human dignity crowd around the beeping hospital equipment.

What is needed is to address the fiscal imbalance — not all at once, but with a credible program that phases in over time. If anything, Mr. Obama has done the opposite by putting forward inadequate and noncredible proposals while failing to prepare the American people for the difficult decisions he will leave for his successors.

In the face of this approach to fiscal policy, so aptly labeled by Keith Hennessey as a strategy of “whistling past the graveyard” and so at odds with the self-righteous tone of President Obama’s first budget with its cover proclaiming “A New Era of Responsibility,” it is difficult to blame Republicans for pushing for fiscal restraint in any way possible.

Hence the fiscal situation that will be rejoined when Congress returns from recess next week. Perhaps the most that can be hoped for is that grave issues presented by the Syrian atrocities will lead to a budgetary cease-fire rather than a stalemate.  Under this sequence of events, the debt ceiling will be raised and bond default averted, while the inartful spending changes of the sequester remain in place rather than a more thoughtful and gradual approach to addressing the nation’s fiscal challenge.  This outcome would be satisfactory to no one but better than the alternatives of bond default or government shutdown.

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