A deal that extends unsustainable tax cuts for 98% of Americans is no victory, says Nouriel Roubini.
The deal reached in Washington on New Year’s day prevented the US economy from falling off the so-called fiscal cliff. However, given the dysfunctional nature of the American political system, it won’t be long before there is another crisis.
Two months, in fact. If no action is taken by March 1, $110bn of spending cuts will commence. At about the same time, the US will hit its statutory debt limit, known colloquially as the debt ceiling.
That is only the beginning. Later in 2013, and not before time, a bigger debate on medium-term fiscal consolidation will begin. This will lead to another dispute between Republicans, who want to shrink the size of the federal government, and Democrats, who want to maintain it but are unsure how to pay for it.
So expect a big fight about entitlements, and a series of little fights over tax reform: should the US introduce a value added tax? A flat tax? Higher (or lower) income taxes? A carbon tax? Should we close corporate tax loopholes to raise more revenue? It’ll soon get messy.
President Barack Obama and his allies will argue that the deal concluded on Tuesday raises only $600bn of revenues over 10 years rather than their initial target of $1.4tn – and therefore there is further room for tax rises, at least for the wealthy. Republicans will argue that spending should now be radically cut, since this week’s deal did not address that side of the national balance sheet. (Even the 2011 debt ceiling deal reduced prospective spending by $1tn).
In the meantime, the likely fiscal adjustment in 2013 will be about 1.4 per cent of gross domestic product. (Spread between the expiry of the payroll tax cut, the increase in the tax rates of the rich, and some eventual cuts to spending.)
This translates into a 1.2 per cent of GDP drag on the economy during the year. If the economy was happily growing above trend – at say 3.5 per cent – that would not be such a big deal, as growth would still be above 2 per cent. In the past few quarters growth already averaged about 2 per cent. So the US could quite easily come perilously close to stall speed this year – or worse, if the eurozone crisis worsens.
The longer-term picture is bleaker still. The reality is that America is yet to wake up to the full extent of its fiscal nightmare. Even the typical Republican voter is not – being on average older and poorer than a Democrat voter – in favour of gutting the welfare state. Tea Party extremists are more noise than signal. That is why the plans of Mitt Romney and Paul Ryan, the Republicans’ losing presidential ticket, postponed all the tough spending cuts on Social Security and Medicare by a decade.
Neither Democrats nor Republicans recognise that maintaining a basic welfare state, which is right and necessary in our age of globalisation, rapid technological change and demographic pressure, implies higher taxes for the middle class as well as for the rich. A deal that extends unsustainable tax cuts for 98 per cent of Americans is therefore a pyrrhic victory for Mr Obama.
For now, he is being helped by the quiescent financial markets. It will probably take years for the US to confront the reality of its fiscal position and raise revenues to a level sufficient to fund a reformed – but not gutted – welfare state. Large fiscal deficits will remain the norm for the next few years, at least so long as the bond market remains quiet, as I believe it will.
Bond market “vigilantes” have no appetite for destruction. Why should they? Growth is low and inflation lower; the US still has the global reserve currency; US Treasuries remain haven assets; interest rates are at zero; the US Federal Reserve is committed to QE; and China and other emerging economies will keep accruing US dollars to resist appreciations in their own currencies. All this guarantees the cheap financing of the US deficit for years to come. But eventually, the vigilantes will wake up.
In short, the “mini deal” on the fiscal cliff dodged all the important questions. By not including spending cuts in the deal, the Democrats have emboldened Republicans who are determined to slash taxes but lack a plan to pay for it. It is again up to Washington’s policy makers to fix the problem before the market does it for them. Tuesday’s deal suggests this will not happen with any ease.