October 23, 2011
Even if the European Lack of Union does, miraculously, come up with some short-term resolution of a mathematically unsolvable crisis (at its core, the problem is that there is simply far more debt than there are assets, let alone cash flow, period, end of story) suddenly the market’s will refocus its attention on the question of our own intractable math: i.e., how will America, suddenly once again the “neo-decoupled” source of global growth (don’t look now but the Shanghai Composite is at multi-year lows even post the bank bailout from two weeks ago so the “dynamo” sure won’t be Beijing), proceed to lead the world out of its latest slump?
The answer is simple – it won’t. At least not according to Goldman Sachs, which once again focuses on what everyone so conveniently chooses to ignore – the complete fiasco that is America’s fiscal situation.
Here is a reminder: “The fiscal policy outlook is unusually uncertain, and this uncertainty will persist even after the “super committee” reaches a decision by its deadline roughly one month from today.” The European math is not the only one that does not work: “Even if reforms are agreed to next month, further legislation will need to be passed next year to address the expiring 2001/2003 tax cuts and the potential constraint of the statutory debt limit (again). Some lawmakers may also want to intervene to alter the automatic spending cuts that would take effect in early 2013 if the super committee fails to reach its $1.2 trillion deficit reduction target.” For those who enjoy solving insolvable problems: you take your 2.0% (tops) Q3 GDP, and cut it by 2.5%, and that’s the growth rate in 2012.
Why? “In FY2011, several temporary provisions added to the budget deficit. These included the payroll tax cut; emergency unemployment compensation; spending from the American Recovery and Reinvestment Act of 2009 (ARRA), and expensing for corporate investment.
Together, these account for almost 2.5 percentage points of GDP in FY2011.” With the GOP dead set on making the president seem like an economic disaster, you can kiss these “temporary” boosts goodbye. And, the kicker, as far as the president is concerned, is that as Steve Jobs predicted, he most likely will not have a second run for one simple reason. “Based on our FY2012 deficit forecast along with non-deficit financing needs and accumulation of Treasuries in federal trust funds (which count toward the debt limit) borrowing authority might be exhausted by November or December of 2012, not long after the presidential election.” Or, not long before the presidential election if the US continues to spend at the current rate. In which case, Jobs will be once again 100% spot on.
Full Goldman note on America’s unsolvable math problem:
The Super Committee and the Fiscal Cliff
The fiscal policy outlook is unusually uncertain, and this will continue even after the congressional debt “super committee” reaches a decision this fall. Even if some reforms are agreed to, further legislation is likely to be considered late next year to address the expiring tax cuts and the potential constraint of the statutory debt limit (again). Some lawmakers may also want to intervene to alter the automatic spending cuts that would take effect in early 2013 if the super committee fails to reach its $1.2 trillion deficit reduction target.
The negative fiscal impulse looks likely to top 1% of GDP in each of the next two years. However, the outlook still warrants a more expansive fiscal policy in the near term, coupled with a credible longer-term deficit reduction plan that exceeds the super committee’s target, but enacting legislation to bring this about looks challenging on both counts.
How Big Is the Imbalance?
Fiscal year 2011 came to an end a few weeks ago, turning in a deficit of $1.299 trillion, slightly above our estimate of $1.275 trillion. This is essentially unchanged in nominal terms from the FY2010 deficit of $1.294 trillion, as well as our estimate for FY2012 of $1.250 trillion. While the deficit has remained roughly constant in nominal terms—as a share of GDP it has declined slightly to 8.2% of GDP in FY2011—the source of the deficit has shifted among three factors:
1. Cyclical effects. Economic weakness likely accounts for about one quarter of the total 8.2% of GDP deficit reported for FY2011, which ended September 30 (see Exhibit 1). For FY2012, CBO assumes that below-potential output will contribute 2.2 percentage points of GDP to the budget deficit, and our estimates imply a similar effect.
2. “Temporary” policies. In FY2011, several temporary provisions added to the budget deficit. These included the payroll tax cut; emergency unemployment compensation; spending from the American Recovery and Reinvestment Act of 2009 (ARRA), and expensing for corporate investment. Together, these account for almost 2.5 percentage points of GDP in FY2011.
3. Structural imbalance. Taking out the cyclical influence as well as the temporary factors from the budget balance leaves a structural imbalance in FY2011 of roughly 4% of GDP. At present, this works out to just over 1% of GDP in interest expense, and roughly 2.5% in “primary” imbalance not due to cyclical factors or temporary policies. Gradual elimination of the primary deficit should be the highest priority for lawmakers.
We have extended our preliminary deficit estimate out to FY2014, pending the outcome of the super committee. The estimate, shown in Exhibit 1, reflects recent revisions to our economic forecast as well as recent policy developments. While our deficit estimate of $1.25 trillion for FY2012 still looks on target, we expect somewhat larger deficits than we had projected in February for the following two fiscal years, as a result of two factors working in opposite directions.
1. Lower growth. Our recent forecast revision downgraded growth expectations for Q4 2011 and the first three quarters of 2012. This makes for a lower starting point for revenues going into FY2013.
2. Policy changes. Working in the other direction, the debt limit agreement reached in early August, formally known as the Budget Control Act of 2011 (BCA), sets a nominal cap on congressional appropriations over the next ten years. This reduces the deficit compared with our prior estimates, which had assumed that congressional appropriations rise with real GDP over the long run, with a gradual phase down of spending on overseas military operations. We assume that relief from the alternative minimum tax (AMT) and the tax cuts enacted in 2001 and 2003 will be extended once again as they were in 2010, along with a one-year extension of the 2 percentage point payroll tax cut through 2012, and business tax incentives.
A Super Committee Agreement Seems Likely
Congress took the first step in reducing the long-term imbalance with the BCA, which in addition to spending caps instructs the super committee to identify another $1.2 trillion in deficit reduction measures (this figure includes associated interest savings). Under the BCA, any shortfall in the super committee’s package relative to its $1.2 trillion deficit reduction target must be made up through automatic spending cuts starting in 2013, a process known as “sequestration.”
Given scant information coming out of the super committee discussions and the broad range of topics being considered, the outcome could go a number of ways. That said, we still see an agreement of some type as the most likely scenario, probably involving a reduction in spending of a few to several hundred billion, coupled with a much smaller amount of new revenue. The former would come from a variety of policy changes related to Medicare, Medicaid, and non-healthcare mandatory programs. The latter would most likely come from increased fees, one-time revenues from spectrum auctions and other federal sales, as well as the elimination of a few targeted corporate tax preferences.
Of course, other scenarios are possible. The approaching election and fundamental policy differences could render an agreement impossible. But congressional approval ratings are near record lows, while the public’s focus on fiscal issues is the highest it has been since the 1990s (Exhibit 2). We think that this, along with the threat of defense spending cuts that would take place absent a deal and the possibility of using the super committee to enact economic stimulus measures, will lead a majority of lawmakers to support an agreement.
While also possible, it is much harder to see an agreement reaching or exceeding the $1.2 trillion target. As best we can tell, personal income tax increases are off the table, along with benefit or eligibility reductions in Medicare and Social Security. The remaining areas of the budget are probably too small to produce the necessary savings without disruptions to programs that might be politically unacceptable.
The super committee has until November 23 to vote on its recommendations. The logistics of the process will probably mean that an informal agreement will need to have been reached the prior week, to allow time for cost estimates and legislative drafting. If we assume that the required simple majority of the 12 super committee members end up voting in the favor of a deficit reduction package of some kind, the effects are likely to be judged along four lines:
1. Timing of cuts. Deficit reduction from the super committee is likely to be more backloaded than the automatic spending cuts that would take place absent an agreement. For illustrative purposes, Exhibit 3 shows the effect on the federal deficit of the various proposals dealing with health and other mandatory spending compared to the automatic cut. The President’s proposal, for instance, would actually increase spending slightly in FY2012, even when excluding his jobs proposals. In FY2013, the proposals range from 0.1% of GDP to 0.3% of GDP, all implying less restraint than the sequester.
2. Forward looking process. The super committee package might also establish a process for Congress to address tax reform and possibly entitlement reform. This would potentially involve instructions to the tax-writing committees to pass legislation by a given deadline that achieves a given amount of deficit reduction. But what the deadline would be—2013 seems realistic, 2012 less so—is unclear, as is what the targeted amount of savings would be, and the penalty for failing to reach it. Without a binding deadline that carries penalties for inaction, we suspect that markets will view such a process as an interesting political marker but would not meaningfully increase the likelihood assigned to those reforms taking place.
3. Stimulus measures. Our forecast assumes an extension of the payroll tax cut currently in place, as well as hiring- or business-focused tax incentives, but we do not assume extension of emergency unemployment compensation (EUC). The most likely path for these measures seems to be inclusion in the super committee package, but whether this happens will depend on the size and composition of the deficit reduction recommendations. Fitting $100bn to $150bn in stimulus into the super committee bill will be much easier if the overall package is at least halfway toward its $1.2 trillion goal, but there may not be room in a deal that saves only a few hundred billion.
The composition of savings also matters; the President’s proposals have support mainly from Democratic members of Congress, so the savings to pay for them would need to come predominately from items Republicans support, such as deeper reductions in spending on “mandatory” programs. Although there is some risk that the tax-based measures we expect might not be extended, there is also a fair chance that Congress will end up extending EUC for another year, as many Republicans have signaled some openness to renewing benefits if accompanied by reforms. As such, we see the risks in this area as roughly balanced. Exhibit 4 shows the effect of extending none of these provisions, only the payroll tax cut and business-focused incentives, and the President’s entire proposal, including extension of EUC.
4. Rating agency reaction. Further sovereign downgrades remain a significant risk. Two of the three major agencies have assigned a negative outlook to their rating and all three cite the need for greater fiscal consolidation efforts, as summarized in Exhibit 5. Slippage in current deficit reduction plans—such as super committee failure combined with intervention in the automatic spending cuts—could result in negative ratings action, though the consequences of the S&P downgrade proved to be modest, as expected.
The End of the Beginning
The super committee’s legislative package may be the last major fiscal legislation enacted before the upcoming presidential election (November 2012). However, the need to address additional issues by year-end 2012 and the likelihood of an attempt at broader structural reforms in 2013 imply that this year’s reforms are the beginning of a multi-year fiscal reform process. In 2012, we see three potential issues Congress will consider:
1. The spending “sequester” for 2013. As noted above, the super committee faces a target of $1.2 trillion in savings over ten years. If it fails to reach that goal, spending cuts take effect in January 2013 to make up the difference between whatever savings have been achieved and the $1.2 trillion target. Our super committee scenario implies automatic cuts of at least a few hundred billion over ten years. If this proves correct, some lawmakers may attempt to modify or reduce the automatic cuts, particularly related to defense. As noted earlier, slippage in this year’s fiscal agreement would be closely scrutinized by rating agencies.
2. The scheduled expiration of the 2001 and 2003 tax cuts. The personal income tax cuts that were enacted in 2001 and 2003 and extended for two years at the end of 2010 must once again be addressed by Congress. To let them expire in their entirety would result in a sharp reduction in disposable income on the order of 1.8% of GDP. Our budget deficit estimates assume that they will be extended in their entirety at the end of 2012, since (1) the weak economy drove Congress to extend them at the end of 2010 and our forecast implies a similar economic situation in 2012, and (2) Democrats, many of whom oppose extending the upper income tax cuts, are unlikely to have greater control following the next election than they did at the time of the last extension.
3. Another increase in the debt limit. Unfortunately, it appears that at the same time lawmakers are confronted with these other two issues, they will also once again need to raise the statutory debt limit. Based on our FY2012 deficit forecast along with non-deficit financing needs and accumulation of Treasuries in federal trust funds (which count toward the debt limit) borrowing authority might be exhausted by November or December of 2012, not long after the presidential election. Exhibit 6 shows the projected level of debt subject to limit, against (1) the debt limit of $16.394 trillion, (2) that limit increased by $230bn (the amount of extra borrowing authority the Treasury might be able to tap by disinvesting certain government trust funds) and (3) that amount, increased by another $300bn, which represents the higher debt limit that would be established if the super committee were able to reach an agreement of at least $1.5 trillion.
Peering over the Edge of the Fiscal Cliff
While our baseline assumption is a negative impulse of around 1 percentage point in 2012 and 2013, there is a small possibility of a much larger amount of fiscal restraint. Exhibit 7 shows the year-over-year legislated changes in tax and spending policies in each of the next several fiscal years. This is calculated by adding the estimated change in the CBO’s baseline due to legislation over each forecast revision that covers the year in question. This method allows us to incorporate the effects of a variety of legislation not incorporated in the bottom-up method used in Exhibit 4. The results of the two methods are similar, and show substantial fiscal retrenchment over the next few years, even assuming extension of the payroll tax cut for one additional year through 2012, extension of the 2001/2003 tax cuts throughout the period, and subtracting the effect of the automatic spending cuts set to take effect in 2013 if the super committee does not agree on $1.2 trillion in savings. This would work out to slightly more than 1% of GDP in 2012, and nearly 1.5% in 2013.
Given the trajectory of federal debt over the longer term, Congress will clearly need to look at additional fiscal consolidation measures to stabilize and ultimately reduce the debt level. That said, enacting more long-term deficit reduction—particularly structural reforms to entitlement programs and the tax code—in return for less restraint in the next year still appears to be a trade-off worth making.
This article was posted: Sunday, October 23, 2011 at 6:08 am