Bernanke Cliff Analogy Overstates Immediate Economic Harm
While the U.S. Congress views the convergence of more than $600 billion in tax increases and spending cuts set for Jan. 1 as a “fiscal cliff,” the metaphor misses the economic reality of what could follow.
The image popularized by Federal Reserve Chairman Ben S. Bernanke describes an immediate plunge, not the series of compounding events that could occur if congressional leaders and the president fail to compromise.
“Cliff conjures up Wile E. Coyote, and January comes, and all of a sudden you plunge into a deep recession inevitably and it all happens fast,” said Chad Stone, chief economist at the Center on Budget and Policy Priorities in Washington. “That’s not the way things would unfurl.” He said he prefers the term “fiscal slope” to describe how the effects would accumulate gradually during 2013.
Congress created the conjoined deadlines on tax and spending policy as a way to prod itself to resolve long-running disputes on fiscal issues. The cliff metaphor has reinforced the need for action, shaping the debate for more than nine months and increasing pressure for Congress to avert at least some of the tax-and-spending changes.
While negotiations have stalled over President Barack Obama’s demand for higher tax rates for top earners and congressional Republicans’ insistence on structural changes to entitlement spending, a Republican aide says those talks will narrow to conversations between Obama and House Speaker John Boehner. Failure to reach an agreement by year’s end could mean, in keeping with the metaphor, going over the cliff.
The Congressional Budget Office estimates that the U.S. would probably enter a recession in the first half of 2013 if Congress doesn’t act to avoid the tax increases and spending cuts. The unemployment rate would climb to 9.1 percent in the fourth quarter of 2013 from 7.7 percent in November 2012, CBO projects.
Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC, said critics of the cliff image understate the potential for business investment to decline and for financial markets to react negatively to legislative gridlock.
“The folks who argue that it’s a fiscal slope are really ignoring the psychological impact that it would have on the business community,” Dutta said. “We face a cliff in the sense that this would be a notorious political failure if Congress failed to avert a recession, because that’s effectively what the government is threatening right now.”
Financial markets are operating under the assumption that Congress will reach a deal by the end of the year or early January, said Alec Phillips, a political analyst and economist for Goldman Sachs Group Inc. (GS) in Washington. There is “not a lot of indication right now that the market is expecting an adverse outcome,” he said.
“People who describe it as a slope have a point, which is that the world doesn’t necessarily end on Jan. 1, if people assume the issue will be fixed very soon,” Phillips said. “At the same time, it seems pretty clear that if they don’t address the fiscal restraint that’s built into current law within a reasonable period of time, a cliff and a slope are essentially the same thing. The only difference is just the angle.”
When lawmakers have expressed optimism about a deal, stocks have risen. Prices have dropped when they say negotiations are stalled, giving hints at the potential for market declines if talks fail.
Standard & Poor’s
The Standard & Poor’s 500 Index (SPX) declined 0.5 percent in three minutes on Nov. 29, erasing an earlier rally, after Boehner said “no substantive progress” had been made toward a deal. Bond markets have gained on pessimistic news. The benchmark 10-year Treasury note yield fell for the fifth of six weeks ending Nov. 30 as Obama warned that day of “prolonged negotiations” ahead on deficit reduction.
To bolster his point that the cliff is more of a slope, Stone points to the components of the scheduled fiscal contraction and how they take effect over time. Those effects can be reversed if a deal is reached early in 2013, he said. There are several other fiscal deadlines in 2013 that could push Congress to act, including the need to raise the $16.4 trillion debt limit.
If Congress doesn’t act, the policy changes include higher income tax rates at all income levels, the end of a 2 percentage point cut in the payroll tax, higher tax rates on capital gains, estates and dividends, and automatic spending cuts, about half in defense programs.
Most of the effects would occur over the course of the year. Because most taxes are collected through paycheck withholding, only a fraction of the effect occurs each week or month.
The spending cuts operate in a similar way because agencies spend money over time, not in lump sums at the beginning of the year.
The Economic Policy Institute, a Washington group that favors policies that benefit workers, prefers the term “fiscal obstacle course” to convey the staggered effects.
Consumers so far are unperturbed by the possibility of tax increases and loss of benefits. The Bloomberg Consumer Comfort Index last week held near a seven-month high. The Thomson Reuters/University of Michigan index of sentiment climbed to a five-year high in November, and the Conference Board’s sentiment index last month reached the highest level since February 2008.
The three measures slumped last year when lawmakers debated whether to raise the nation’s debt ceiling.
A better housing market is feeding into their optimism by boosting household wealth and may make up for some growth lost to fiscal uncertainty next year. Residential investment could contribute as much as 0.6 percentage point to gross domestic product in 2013, according to Joe LaVorgna, chief U.S. economist at Deutsche Bank in New York. Homebuilding probably added 0.3 point to the expansion this year, the first contribution since 2005.
Businesses in the U.S. have begun to reduce investment in anticipation of fiscal restraint. Spending on equipment and software has slowed for three straight quarters. It dropped 2.7 percent from July through September, the first decline since 2009, when the economy was exiting the recession.
A more recent pickup in demand may mean business investment will rebound next year if lawmakers reach a budget deal. Orders for non-defense capital goods excluding aircraft, considered a proxy for future business spending, rose 2.9 percent in October, the most in eight months and following a 0.5 percent decline in September, according to Commerce Department data.
Bernanke was the first prominent official to describe the policy changes scheduled for 2013 as a “fiscal cliff.” He used the phrase on Feb. 29, during a hearing of the House Financial Services Committee, and it became a staple of the lexicon of lawmakers and political commentators.
Bernanke declined to comment on the appropriateness of the terminology. He used the term “fiscal cliff” in his most recent public remarks on Nov. 20.
Senator Mark Begich, an Alaska Democrat, described the “fiscal cliff” as “probably the most-known phrase in politics now.”
Cliff imagery has been a part of U.S. policy discourse for more than 100 years, Stephen Carter wrote in a Bloomberg View column Nov. 29.
“In short, we can safely say that the image of finances hanging at the edge of a cliff or precipice or escarpment goes back a long way,” wrote Carter, a professor at Yale Law School.
The cliff metaphor has created pressure to reach a deal when many of the economic and market effects of inaction would be reversed if Congress reaches an agreement in early 2013, said Stone, whose group advocates policies that benefit low-income households.
“It’s very effective if you in fact can convince people that going past it would be catastrophic,” said Martin Medhurst, a professor of political science at Baylor University in Waco, Texas, who studies political communication. “If it gets to the point where it does go past the deadline, then you could always recalibrate and adopt a different metaphor.”
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