Throwing My 2 Cents in Over the 'Fiscal Cliff'

Should we look back to 1990 for the path forward?

Pundits, congressional leaders and the President have taken to referring to the anticipated effects of the 2011 Budget Control Act, if allowed to come into effect, as a "fiscal cliff". However, I have started to come to see this piece of legislation as the kind of fiscal shock therapy needed to reset the calculus and set our fiscal ship back upright.

Here is what the fiscal cliff involves:

• Expiration of the Bush-era tax cuts.
• I believe that these tax cuts MUST be allowed to expire, since they ballooned the debt.
• Across the board spending cuts.
• These cuts only amount to 0.25% of all spending, and are hardly draconian.
• Setting the alternative minimum tax back to 2000 levels.
• Once again, somebody has got to pay for all of this spending.
• Expiration of the 2% Social Security tax cut.
• In my opinion, either we keep Social Security or we dump it; if we keep it we need to strengthen it, not weaken it.
• Expiration of Federal unemployment benefits.
• I have mixed feelings about this one -- however, unemployment benefits cannot be paid out into perpetuity, even if the economy is weak, so their expiration is probably needed, in spite of serious near-term discomfort for the long-term unemployed.
• New taxes associated with Obamacare.
• The up-front costs of Obamacare are going to be a shock to many, even though there are significant savings forecast in later years. Obamacare is a gargantuan piece of legislation and the adoption pains will be many, but the nation has decided that this is the path that we want to follow, so follow it we must.

Taking all of these points into consideration, my biggest complaint about the "fiscal cliff" is that it isn't steep enough! While the increases in revenue are needed, not nearly enough emphasis is placed on spending cuts.

As I have explained in a previous post, the size of the U.S. Budget, at least on a per-capita basis, is far, far too large. We could get by with a federal budget 25% or 35% smaller (taking us back to levels of per capita federal spending that prevailed under Bill Clinton), but the net effect of the "fiscal cliff" would reduce government spending by only 0.25%, according to GAO estimates. That being said, the "fiscal cliff", if enforced, is expected to put us on a much healthier fiscal track, as shown in this graphic (courtesy CBO):

The brown area is where we are headed if we stop the "fiscal cliff" and change nothing, and the baby blue area is were we are headed if the "cliff" takes effect. Clearly, we do not want to be in the brown area.

While the CBO projections seem promising, we must not forget that we already have an absolutely HUGE amount of public debt that must be periodically refinanced, and the "fiscal cliff" does nothing to reduce the amount of that debt since CBO forecasts call for continued deficits for at least the next ten years.

Therefore, I call for a 2 for 1 plan: target $2 of spending cuts for every $1 in revenue increases. My estimates are that, if we permit the "fiscal cliff" legislation to take effect and couple it with 2x the amount of new revenue in the form of government spending cuts, we will reduce the total public debt (not simply the deficit) by about HALF in ten years.

How will this work? Current estimates are that the "fiscal cliff" will increase revenue by about $500B in 2013; if combined with $1T in spending cuts, the federal government would be expected to see a surplus in year one. By year 10 we would expect to see a cumulative surplus of about $8T, against the backdrop of over $16T in public debt. I am making the assumption here that a constrictive effect on GDP of the reduced government spending in the early years will be offset by strong growth in the later years, leading to a net that is positive in terms of GDP growth over the ten year period in question. $1T in spending cuts in 2013 would be about a 26% reduction in budgeted spending. Clearly, to reach this goal, no program can be "off the table." In fact, the only spending category that is off the table is the service to the debt, which is protected by the 13th Amendment to the Constitution, and which will ruin us if we don't deal with it now. Therefore, I believe that there is consensus in the nation to combine revenue increases with spending cuts to put the brakes on this runaway debt train.

Why is this important? While interest rates are currently low, they are bound to rise in the future, and when they do the interest portion of the debt will grow to consume a larger and larger portion of our public discretionary revenue, forcing cuts and cancellations of millions of much-needed programs or exploding the debt even further. Additionally, the buyers of our debt will grow more and more skeptical of our ability to balance the budget and will demand a progressively higher "risk premium" at auction until the auctions fail outright. The federal government and Federal Reserve have injected huge amounts of liquidity into our financial system which must be absorbed. If we keep the "fiscal cliff" and combine it with huge spending cuts we can prevent the fiscal collapse and runaway inflation that are just over the horizon.

While no solution is popular or attractive, the least attractive option, in my opinion, is to do nothing and wait for the global financial markets to make our decisions for us.