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Re-Elected Obama Looks at Fiscal Cliff

Will Republicans refuse to raise taxes and jump into the abyss?

By David Dapice Created: November 11, 2012 Last Updated: November 13, 2012
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House Speaker John Boehner (R-Ohio) makes remarks on Capitol Hill on Nov. 7 in Washington, D.C. Boehner discussed the looming fiscal cliff and called on President Obama to work with House Republicans. (Brendan Hoffman/Getty Images)

House Speaker John Boehner (R-Ohio) makes remarks on Capitol Hill on Nov. 7 in Washington, D.C. Boehner discussed the looming fiscal cliff and called on President Obama to work with House Republicans. (Brendan Hoffman/Getty Images)

With the election over, President Barack Obama again must face a divided Congress that brought the United States to the brink of default last year. As they return for a lame-duck session—the Senate on the Nov. 7 and the House on the Nov. 13—they will confront a mess of their own making.

Last year, when they could not agree through normal channels on a mix of tax increases and spending cuts to reduce the budget deficit, they agreed to “sequestration”—an unpalatable mix of defense and entitlement spending cuts that would be triggered if a special committee could not come up with a compromise package. They did not agree, and now the cuts are due to begin on Jan. 1, 2013.

Congress may cooperate. With Obama unable to run again, there would be less reason for them to adopt scorched-earth tactics.

In addition, the Bush and stimulus tax cuts will expire at the end of 2012. The combination of tax increases and spending cuts, called a “fiscal cliff,” will be worth about $800 billion or 5 percent of GDP in calendar 2013. Since GDP growth without a fiscal cliff is only projected at about 2 percent, the result would be a sharp contraction in economic activity, though experts disagree on how bad it would be.

The International Monetary Fund (IMF) recently warned about excessive austerity and stated the global economy was at risk for a severe slowdown. It urged the European Union to ease up on extreme austerity because, it argued, it would actually depress tax revenues more than spending cuts and worsen government deficits. In the United States, the IMF argued that some short-term fiscal ease should be combined with longer term cuts so that the medium- to long-term threat of very high deficits would be contained while short-term weakness could be dealt with.

The argument was that during periods of very low interest rates, the fiscal multiplier—the change in GDP divided by the change in spending or taxes—is actually higher than normal. They suggest a multiplier of 1 to 1.5 rather than one-half is more likely now, since monetary policy has only a limited ability to offset fiscal contraction as it normally would. If this analysis is correct, driving completely off the fiscal cliff would be catastrophic for the United States and possibly the world economy. A $1 trillion contraction in demand would drive up unemployment, depress tax revenues, and cut import demand. This argument is broadly Keynesian, but is augmented by the evidence that austerity is self-defeating in fiscal terms.

Wall Street seems to think that Congress will find a way not to jump off the cliff. The S&P stock market index is up for the year and not that far from all-time highs. Stock prices tend to be forward looking. Why should there be accommodation now when there was such gridlock previously? One reason is that the elections are over. Senator Republican leader Mitch McConnell’s famous observation that the top political priority of Republicans was to deny President Obama a second term would be moot.

With President Obama unable to run again, there would be less reason to adopt scorched-earth tactics. Another reason is that Wall Street itself would suffer from driving off the cliff and pressure Congress through lobbyists to avoid it. A third reason is that the public seems to be dubious of extreme Tea Party tactics and has indicated by voting that it wants the two parties to work together.

There is good reason to hope that this optimistic stance is correct. With the Federal Reserve already holding short-term interest rates near zero and buying $40 billion a month in bonds and mortgage securities, there is little more that it can do to cushion such a huge hike in taxes and cuts in spending. While housing seems to be stabilizing and is in the early stages of a recovery, there is little doubt that the tentative and rather weak U.S. recovery would collapse if existing tax and spending laws were left unchanged.

The really bad scenario is if a combination of EU recession, U.S. fiscal tightening, and Asian slowdown interacted and fed off one another. In that case, the decline in global growth would extend well beyond what any single shock would predict. The leading nations in the world united to fight economic collapse in 2008–2009 by providing a mix of monetary and fiscal stimulus. There does not appear to be any similar consensus now, so each country will have to be prudent without the knowledge that others will also support the global economy.

If only one nation increases demand while others hold back, much of the demand stimulus would leak out into import demand, without the stimulating nation’s exports getting a similar boost. This would weaken the effectiveness of the stimulus policy and possibly lead to balance-of-payments problems.

Health Care Costs

However the fiscal cliff is managed, there is still the very real medium- to long-term issue of dangerously rising U.S. deficits, driven mainly by growing health care costs and federal entitlement programs such as Medicare and Medicaid. The rejected Romney–Ryan approach was to limit the amount the federal government would spend and let markets for Medicare and the states for Medicaid sort out the cost and type of insurance that the elderly and poor could receive. The Obama approach has been to try to discern what treatments are cost effective and possibly change the incentives in medical care.

Medicare pays per procedure, so health care providers produce lots of procedures. If there were payments per person through health maintenance organizations, the incentive would be to manage health care more efficiently and avoid marginally needed or unnecessary tests and treatments. This approach is used in other nations and being introduced in Massachusetts, which in 2006 adopted a version of the current national health care program.

If the cost curve can be bent and health costs per person reduced, the long-term fiscal gap would become much more manageable. The Medicare population will grow over 2 percent a year in the coming decades as baby boomers retire, so some restraint in per capita health care costs will be needed. There are also issues with Social Security, but they are much smaller and could be managed by a plausible mixture of limiting benefits at the top end and raising the salary cap subject to the Social Security tax.

This second long-term fiscal issue is more serious than the short-term cliff, since it will require a level of bipartisan cooperation that transcends short-term deals. If health care costs are allowed to absorb virtually all revenues—as they would on current trends in the next decade—the ability of the federal government to fund anything else would be severely limited.

In terms of generational equity, it makes no sense to cut programs for infrastructure, education, research and development, and even national defense because our health care costs per capita are 50 to 100 percent above those of other advanced nations. In 2010, the United States spent 122 percent more per capita than Sweden on health care in dollars adjusted for purchasing power! An ability to tame this second deficit while improving the coverage and quality of medical care is a huge challenge that a second Obama term would do well to address.

David Dapice is associate professor of economics at Tufts University and the economist of the Vietnam Program at Harvard University’s Kennedy School of Government. With permission from YaleGlobal Online. Copyright © 2012, Yale Center for the Study of Globalization, Yale University.

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