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Fiscal Cliff

The Leap Never Took

Muhammad Mutahir Ali

"I hope it won't happen, but if the fiscal cliff occurs, I don't think the Fed will be able to help. These were the words of Ben Bernanke, the chairman of the Federal Reserve of United States during his testimony in front of Congress. We cannot offset the full impact of the fiscal cliff -- its just too big, given the tools we have available and the limitations on our policy toolkit, he continued in his speech, in February 2012, as he coined the phrase Fiscal Cliff.

Since then, the would-be scenario of America going over the Fiscal Cliff became the talk of town in economic circles all over. An already recession-hit economy of United States began to feel more ripples. Newspapers flooded with the sketches of an after Fiscal Cliff economy, investors trust began to shook, and stock market started panicking as the general American public speculated on its economic fate. Everyone took their guesses on whether or not America will be able to avert Fiscal Cliff. Debates began and negotiations took off amongst the America Policy Makers, as 1st of January 2013- the D-day of Fiscal Cliff, came closer. The days prior to the January 2013 witnessed dramatically intense and eventful moments which ended up in ways which would have far-fetched impacts on American Economy.

This case study is set to provide an anecdotal account of whole Fiscal Cliff episode. It takes a look into the events which lead American economy to Fiscal Cliff deadline and the happenings which followed it. Readers are expected to understand the implications of Fiscal Cliff thus enabling them to critically analyze the problem and potential solutions that could solve it.

The Economy of United States

The United States economy is the largest national economy. Running up to the combined economy of European Union which is some 2 trillion dollars bigger in GDP, it is the second largest single economy of the world. The US is home to the world's largest stock exchange, the world's largest gold depository and reserves, and 139 of the world's 500 largest companies, which is almost twice that of any other country. As the leading economy in the world, fluctuations in the US economy have far reaching impact around the globe. The structure of US economy can be best described as a Mixed Economy. An economy which, on paper, is run on the Laissez-faire principle however the government has had a history of influencing the economic environment directly and indirectly. Let it be the famous 2008 Banking Bailout 1(where US Government, to avoid recession, provided $ 7.7 trillion directly to banks) to finally the Fiscal Cliff in 2012, the government interventions, whether in the form of regulations or otherwise, have had impacts on the economy.

As a critic once commented on the US economy as Socialism for banks and Capitalism for the rest.

The Government Budget is an important component of any economy. It outlines governments economic policies as well as it provides a thorough plan for its Revenue and Expenditure. Balanced Budget is a situation when Governments Revenues equal the Expenditures i.e. neither a Surplus nor a Deficit arises.

In United States the Federal Budget begins as a presidential proposal (of Revenues and Expenditures) which is then passed by the Congress 2. It is interesting to note that the worlds largest economy has failed to balance its budget since 1998 when, under the presidency of Bill Clinton, the United States had its last balanced budget. Since 1998 US budgets have ran in Deficit. This implies that the government has continued to spend more than what it earns (Expenditures exceeding the Earnings). So how is this Deficit tackled? The answer is fairly simple; Through Borrowings. The US Government either borrows externally (from other countries or monetary organizations such as China or IMF respectively) or internally from the United States Department of Treasury 3 through the issuing of Securities, in the form of Internal Debt.
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Read more on the 2008 Bailout Scheme here : http://goo.gl/jBRPh US Congress is a legislative body of the Federal Govt. of US, like Parliament in Pakistan. 3 US treasury is responsible for acts like printing money and collecting taxes etc

4 However, this does not allow the Government to accrue any amount of debt that it wants to. The law of the United States enables Treasury to issue only a certain amount of National Debt. This licit limit on the internal borrowings of government is known as the Debt Ceiling.

United States Debt Ceiling

As described earlier, the United States Debt Ceiling is a limit on the amount that the Government can borrow for the Department of Treasury. In simple words, if the debt ceiling is set at $100, the Treasury cannot lend more than $100 to the Government. So, in effect if the US Government owes more than $100 to pay some party(e.g. in the form of interest to national bondholders) and Treasury is unable to release more than $100 in debt to government, assuming ceteris paribus, the US Government would default. But in reality, the United States has never reached a point of default so far. Why? Because the Debt Ceiling, in principle, has never actually been effectual.

This is because the United Sates Federal law requires Congress to authorize the government to borrow any money that is needed to pay for the programs that Congress has passed. So, if a Budget for a financial year is passed from the Congress and the Government has to borrow more than what the Debt Ceiling allows it to, to carry out the economic transactions for that financial year, the Congress would

5 alter the Debt Ceiling. And this has been a usual practice as Congress has, in past number of years, raised the Debt Ceiling many times allowing the Government to borrow more than the initial limit.

But, the year 2011 saw a change. The Congress would not raise the Debt Ceiling.

The US Congress mainly consists of representatives from 2 main parties- Democratic Party and the Republican Party (or Grand Old Party- GOP), usually without any single party having the required majority to pass a law. This pronounced that President Barrack Obama, a Democrat, could not get the bill to raise the Debt Ceiling passed from Congress unless Republican candidates endorsed it. But in 2011, GOP led candidates decided to vote against raising the debt ceiling until the Government Spending was trimmered. Both parties had an agreement over reducing the Deficit but differed upon the methods to do so. Hence, a new crisis developed which would see a principle disagreement, between the Republican and Democratic legislators, which needed be addressed preliminarily before the Debt Limit could be enhanced. Primarily, Deficit Reduction could be ensured through two ways. Either the taxes had to be increased or the Government Spending had to be curbed. The majority of Republicans opposed any increase in Taxes and the Democrats opposed any major cuts in Government Spending and vowed to increase the Taxes instead. The dispute continued to expand and crisis intensified. The prophecies made their room between the folksy speculations. Many leading economists predicted disastrous outcomes, of not raising the Debt Ceiling, which included the possible failure of the Government to pay the interest to its national bondholders thereby defaulting on its debt.

However, the crisis finally ended when on 31st July 2011 both parties reached agreement on how to reduce the deficit. The agreement which took the legal name of Budget Control Act of 2011 4, increased the debt ceiling and outlined the methods to reduce the deficit. Under this act, Congress immediately raised the debt ceiling by $400 bn. and enabled the President to request further increases by $500 billion and $1.21.5 trillion in two installments. The Act provided certain Deficit Reduction policies which would incur $917 billion of cuts over 10 years in exchange for the initial debt limit increase of $900 billion. This act, in addition included the following provision ;

If Congress failed to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress could grant a $1.2 trillion increase in the debt ceiling but this would trigger across-the-board cuts ("sequestrations), as of January 2, 2013.] These cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee.
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Read in detail about the Budget Control Act of 2011 here : http://goo.gl/g1cmx

6 Bringing about these spending cuts, provided for in the Budget Control Act, would later know be known commonly as going over the Fiscal Cliff.

United States Fiscal Cliff

By definition, Fiscal Cliff can be called as the sharp decline in Budget Deficit that would have occurred on January 2, 2013 i.e. the day when the aforementioned clause of Budget Control Act would go into effect. Since the Act provided for the significant cuts in Government Spending and Tax Hikes, it was eminent that a common American was mainly going to be at the receiving end of this economic blow. From Agriculture to military to law enforcement almost every sector of economy was destined to be affected.

Predictions set out once again. Some economists maintained that Spending Reductions amounting as much as $ 110 billion in one year would immediately plunge the economy in a Recession where investments will dry up and many jobs will be lost. Ben Bernankes remarks, that If Fiscal Cliff occurred, Fed wont be able to help in his Congressional Testimony in February 2012 ensued an even greater degree of panic. In retrospect, the Budget Control Act 2011, did manage to avert the Debt Ceiling Crisis but paved way for a bigger crisis situation in the form of Fiscal Cliff scenario. Had America gone over the Fiscal Cliff here is a projection of what would have happened;

Maximum tax rate would rise to 39.6% from 35 %. Americans in the lowest 20 percent of the income scale would pay an average of about $400 more in taxes. Middle-income households could pay about $2,000 more in taxes, on average. 4 million more families would be hit by Alternative Minimum Tax. 5 $600 billion cuts (over 10 years) in Defense spending. Health care spending would drop by 2%. 2 million jobless Americans might have lost their federal unemployment aid and Social Securitys beneficiaries would generally become more vulnerable.

These stats were brought up again and again in newspapers, articles, blogs etc to ring the bells, louder by the day and suggest that an Economic Disaster was in waiting and soon enough the shortlived question of should America go over the Fiscal Cliff got replaced by can America be saved from the Fiscal Cliff.

AMT is a flat tax rate over a minimum income threshold.

7 What we witnessed in the months prior to the due date of Fiscal Cliff- January 2013 can be best described as a combination of insecurity amongst the American people and an Economic Indecisiveness amongst the lawmakers. As majority of American public feared, what they considered to be worst, negotiations took off between the representatives of the two congressional parties again. A series of talks took place between Barrack Obama and John Boehner(R) the speaker of US House of Representatives, to reach an agreement before the Fiscal Cliff deadline.

Finally, whilst some predicted otherwise, Obama and Boehner reached a deal to avert the Fiscal Cliff on the New Years Eve which would legally be named as American Taxpayer Relief Act of 2012

The Fiscal Cliff Deal

The overwhelming economic paranoia towards the Fiscal Cliff, be it reasonable or uncalled for, left American Policymakers not many choices other than compromising their standpoints to an extent of reaching an agreement.

Hence on January 1 2013, after an agreement between Republicans and Democrats was reached, Congress passed the American Taxpayer Relief Act of 2012 which President Obama signed into law the next day.

The Act partially addressed both the Revenue and Spending sides to curtail the deficit. Some argue that it did not achieve anything in reality and others maintain that it did what it was meant to- averting a crisis that would have occurred if Fiscal Cliff was realized. At best, ATRA can be defined as something which just absorbed the magnitude of virtually radical economic changes that would have occurred in a Fiscal Cliff Scenario.

Provisions of ARTA meant that the taxes for some would increase and for some the tax breaks would continue: The top marginal tax rate on income was increased to 39.6% from the 2012 level of 35%, The top marginal tax rate on long-term capital gains of was raised to 20% from the 2012 level of 15%. However for individuals with taxable income of $400,000 per year or less the 2012 taxation level would remain. A number of corporate tax breaks were continued as well. Bloomberg reported, "More than 80 percent of households with incomes between $50,000 and $200,000 would pay higher taxes. Among the households facing higher taxes, the average increase would be $1,635, the policy center said. A 2 percent payroll tax cut, enacted during the economic slowdown, is being allowed to expire as of (December 31). The estate tax exemption will remain at $5,000,000 (adjusted for inflation, so approximately $5,120,000 in 2013) Clauses related to the Spending pronounced that the budget sequestration created by the Budget Control Act of 2011 was delayed by two months. Some reductions in Medicare expenditures would follow however. A pay freeze for members of Congress was extended. However Federal unemployment benefits were extended for a year.

This picture is credited to : www.washingtonpost.com

9 The Act received mixed reactions from newspapers, analysts and economists. Some called it inconsequential while others looked at it as a worthwhile effort at averting a crisis. While Americans took a small breather, many argued that a bigger crisis awaited in the time to come as the Government was again expected to hit the Debt Ceiling soon (in mid February). This building scenario again sparked the debate on how the Debt Ceiling should be tackled. This situation, in all likelihood, was en route to be a repeat episode of Debt Ceiling Crisis of 2011which ended by the signing of Budget Control Act 2011 which provided for the fiscal cliff to happen in the first place.

In middle of all this brouhaha, the United States Senate, on 31st January, approved the bill to suspend the current Debt Ceiling of $16.4 trillion. The United States Debt Ceiling now stands suspended until May 19 2013. This however, by no means, has solved the initial malady permanently.

Meanwhile, it is interesting to consider different solutions that are pitched in from all over. Some Democrats have argued that Debt Ceiling should be removed completely. This proposal has been endorsed by some economists as well. A survey of 38 economists from the University of Chicago found that 84% agreed that a separate debt ceiling that is periodically increased could lead to uncertainty and poor fiscal outcomes as the idea of scrapping the Debt Limit completely is beginning to get some merit. 7

Although the final outcome of this building crunch can only be speculated, it is certain that the 11 hour, short-lived escorts of American policy makers in intense crisis situations have not sent a good economic message domestically or globally.
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Read more on the survey : http://goo.gl/UMXaI

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Austerity vs. Growth8

The last couple of years of economic turbulence also provided a unique Opportunity. On one hand, it made lawmakers to frame solutions and allowed the general public to develop a consciousness about Economy; on the other it has provided everyone a chance to discourse over the prospective solutions that may be applied across the globe to address basic economic problems.

To that end, a much lively debate over a past few years has been that of Austerity vs. Growth. All of the disagreements, discussed so far in this document, since 2011 crisis can be likened to this debate. When, Republicans talked of reducing the Deficit in during 2011, they maintained that that should be done through cuts in government spending. This, in other words can be described as adopting a more Austere approach. Whereas Democrats argued that Deficit should be reduced by addressing the revenue side i.e. increasing the Taxes and maintained that cutting expenditure significantly would result in a stunted growth.

In simpler words, if the Government was to decrease spending, it might have to pull out subsidies or discontinue tax breaks or shut down social security programs etc. Hence, these would have a negative impact on aggregate demand of an economy. In turn, industries may close down; future investments may dry up making unemployment level to rise. Thus all of this would result in a negative growth. (However, cutting the Government spending does not exactly reciprocate that these same measures be taken in the case of US. When Republicans demanded cuts in Spending, the major part of their proposal were focused on reducing the Defense expenses i.e. shutting the military bases on foreign land and closing the military operations abroad etc.)

The other argument on this debate advocates somewhat an increase in government spending to bring about Economic growth. For example, if a government decides to give tax breaks or starts giving subsidies or decreases the tax level for all. In this case, government spending would rise but will also have a positive effect on investment and aggregate demand etc allowing the National Income to ultimately increase. It is difficult to conclude whether Austerity always spells a negative impact on Growth or vice versa. However it can be maintained that both a combination of cuts in Expenditure and increase in Revenue is usually a modest way out for a government facing a huge Budget Deficit.
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This section is particularly designed using simpler economic concepts to give an idea of Economic growth. The process of growth is much more layered in reality.

11 Would the smooth sailing of American econom have continued forever had a few Republicans not refused to raise the debt ceiling in 2011? Was the Budget Control Act a solution or just an ingredient to another problem? Should America have gone over the Fiscal Cliff? Was ARTA the best way out of the Fiscal Cliff? These questions do not have any definite answer. Ones response to them is bound to be based on a certain perspective. But there is one thing quite definite. The demon is still hovering over the United States Economy, looking towards the White House and Capitol Hill, screaming Your Deals are not my cure.
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1. Cover Photo Credits : www.caglecartoons.com

authors research on the issue which was aided by newspapers, online blogs encyclopedia and expert opinions. Official corroboration of the said is therefore not guaranteed.

2. The facts and figures presented in the document are based on the