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More Band-Aids, No Antiseptic: A Decision Maker's View Of Fiscal Cliff Policy

 January 16, 2013 02:39 PM

(By Mani) For some time now, central government spending has been growing rapidly and federal government debt has risen to levels not previously experienced. Several temporary budget control programs have been put in place, but these programs were half-measures, and yet continued overspending on public projects and wars have left the government finances in desperate condition.

Easy monetary policy has also been put into place. Unfortunately, economic growth remains disappointing, and the budget/debt problems continue to grow worse with little prospect of getting spending under control.

Currently, deficits finance current consumption;  whereas, past deficits helped finance public infrastructure that added to the physical capital of the nation and, therefore, the long-run growth of the economy.

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"Today, however, deficits finance current consumption through transfer payments that detract from the capital needed for long-run growth," Wells Fargo economist John Silvia said in a note to clients.

The fiscal cliff compromise did not move federal spending commitments in line with the pace of real spending growth. Moreover, such short-run political compromises do not address the long-run economic imperatives facing the United States—nor was that anticipated.

"There is a critical problem here of incentives and time horizon. First, there is no need or even expectation that a political solution is or would be consistent with an economic solution," Silvia said.

Moreover, political decisions are incentivized by the short run—the next election—and this is certainly true in the recent years of nonstop temporary programs (cash for clunkers, stimulus, first-time home-buyer's credit, temporary payroll tax cuts).

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Yet, households and businesses must plan for the long run, the next 10-30 years, and are incentivized by prices and profits. The incentives/goals are not the same. The time horizons are not the same. Perhaps the only bi-partisan item is the growth of the public debt.

Given this inconsistency of incentives and time horizons, how should decision makers, such as CIOs and CFOs of private and public institutions, interpret and act on the latest fiscal deal, and what is the future framework for decision making?

First, a "Grand Bargain" was not the most likely outcome anticipated by the private market That is a straw man employed to make the current agreement appear to be progress when, in fact, there was no real progress, only delay, on the real issue—a sustainable path of federal spending consistent with a 2 percent growth rate in the economy.

"Two percent growth is indeed what we have had for the past three years—wishing for more does not work. There was no real progress on entitlements—that was not anticipated either but there was a sense that some spending restraint would be undertaken," Silvia wrote.

For investors, taxpayers and decision makers, the tension remains between unsustainable federal spending and deficit trends and a seemingly intractable political decision-making process. While the policymakers debate, households and businesses still need to move ahead.

Finally, the fiscal cliff deal and likely stand-alone debt ceiling deal, failed to put into place any mechanism for controlling federal spending over time; therefore, the failure to address long-term spending problems opens the door to a downgrade of U.S. sovereign debt.

This inability to come to grips with the fundamental spending problem, not the acrimonious debate, is the core issue. Debate is healthy and long overdue on entitlements as they make up the largest share of federal spending and the fastest growing segment of spending. However, debate without a fiscal resolution to a path of sustainable entitlement spending is pointless

For decision makers, the fiscal cliff deal sends all the wrong signals and indicates weaker U.S. growth going forward and no real progress in addressing the long-run spending/debt issues. Raising taxes without any control on spending is exactly the wrong composition of fiscal policy moves

"The losses to long-run growth outweigh the benefits of short-run stabilization," Silvia noted.

Doubts about future taxation also impact the pace of innovation and, thereby, higher expected future taxes reduce the incentive for innovation and growth in the long run. Thus, reducing short-run uncertainty through persistent public deficits or surpluses come at the cost of bringing more risk for long-run profits.



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