The Fiscal Cliff – A Done Deal, But How Good?

As I wrote back in December, everyone understood the need for a deal to be made between President Obama and Congress to avoid going over the ‘fiscal cliff.’ That is, to come to an agreement that would avert the scheduled expirations of a host of tax cuts and reductions in spending on programs like defence and social welfare benefits.

But when it comes to negotiations between this President and his Republican counterparts in Congress, anything can and did happen. Over the course of the roughly two months between the President’s re-election and the final deal being signed on January 2 (technically, after going over the cliff), we saw offers and counteroffers made, concessions made on both sides, and much sniping across the partisan divide.

Irrespective of the details of the fiscal cliff deal, in light of the way both sides conducted their policymaking negotiations, how might one best describe the decision making process on an issue of global economic significance?

In a word: shambolic.

In a couple of revelatory accounts of the negotiations (from Politico and National Journal) we learn of how the working relationship between President Obama and Speaker John Boehner fell apart again as they tried to strike a grand bargain to achieve significant deficit reduction, and the long-term solvency of the key welfare programs:  Social Security, Medicare and Medicaid. Indeed it was only at the last minute when Senate Republican Leader Mitch McConnell called on the assistance of Vice President Joe Biden, that a deal much smaller in scope was finally sealed.

Ultimately, for me the story of the fiscal cliff is of another lost opportunity for American policymakers to address their most significant challenges on the national debt and the budget deficit, despite the continued use of commitment devices such as the scheduled expiration of the Bush Tax Cuts at the end of 2012.

But what is a commitment device and how does it to apply to policymaking? Dr Mike Pottenger, a lecturer at the University of Melbourne and a guest contributor on this website, explains:

“In policy terms, an effective commitment device is something that should give policymakers the right incentives to deal with the real problem and make tough decisions. Postponing a decision and hoping people will do the right thing later when it’s really serious isn’t going to do this. That’s like putting off exercising for the rest of the month until you’re really unfit and it’ll take even more effort. What you really want is to make a commitment to an external party. If Congress gave a few billion in bonds to the World Bank, for example, and signed an agreement to have the money paid to Cuba if Congress couldn’t achieve specific objectives, maybe that might work!”

But as we’ve seen repeatedly from Congress, when it comes to battles over the budget, the most common fix is to simply prolong the schedule of expiration; to proverbially ‘kick the can down the road’. And in the final deal that passed in the early hours of New Year’s Day, there were many elements of the fiscal cliff that were simply delayed, including the sequester on cuts to Government spending for another two months.

Dishearteningly for us policy wonks, Dr Pottenger doesn’t think this way of doing things in Congress is going to change any time soon:

“Unfortunately, I think we may well see more of this sort of thing in the future, because it’s worse than the analogous problem of commitment for an individual. With a group of people there are problems of collective action – think the free rider dilemma – that make it easier for individual members of Congress to avoid doing the hard work to negotiate a compromise.”

Credit must be given however to Biden and McConnell for parts of the deal. Namely, the fact they have made permanent the Bush Tax Cuts for the majority of income earners. If these would have all expired at the end of 2012 the likely outcome would have been significant contraction in economic growth and to push up unemployment during the early months of this year. In this, the most noteworthy aspect of the deal is the increase in marginal tax rates from 35% to 39.6% for individuals earning more than $400,000 and couples earning more than $450,000 – something President Obama campaigned on and stood firm on during the negotiations.

There has been much writing of late on how permanent tax cuts have more economic impact than those that are only temporary. Thus making the majority of income tax cuts permanent in concert with the expiration of the politically popular, but temporary, payroll tax cut on most American workers, is considered wise at this time.

In terms of real deficit reduction however, the deal only achieves $737 billion in deficit reduction over the coming decade, primarily through $618 billion of higher taxes on the rich and the resulting interest savings. But it will hardly make a dent in the nearly $10 trillion in deficits the US was on track to rack up in that period.

Ultimately, neither the deal nor the manner of its making sets a positive precedent for future negotiations about the nature of American fiscal policy, particularly as another battle over the Debt Ceiling looms in late February. If not properly addressed, this could have catastrophic effects on the global economy.

So as the American economy continues to gradually recover from the deep-seated effects of the Great Recession, it will be fascinating to see whether the threat of inaction will finally bring about meaningful and bipartisan efforts to right the course of the long-term threats of the budget deficit. Based on what we’ve seen over the last couple of months, I wouldn’t be too confident.

You can follow me on Twitter @CRJWeinberg.