With the enactment of the Taxpayer Relief Act of 2012, a fiscal-drag induced recession is now off the table. While there will be a drag on growth, it looks manageable this year, with a fiscal tightening that shaves growth somewhat less than 1.5%–absent the sequester and assuming a 1:1 multiplier.
If economic growth was more robust, say 3.5%, the adjustment would be no big deal. But growth has been stubbornly slow this cycle and in the past few quarters, it has averaged only about 2%. So the drag may push the economy toward fractional growth. But it does appear that it can absorb these tax shocks and keep moving, however narrowly, buttressed by the housing recovery and the shale oil/gas revolution with a little help from a rising stock market and a friendly Fed providing easy money.
Further, there will likely be some pent-up demand kicking by mid-year, as many businesses put off capital expenditures in 2012 due to the heightened uncertainty over the election and fiscal cliff—this can only be postponed for so long. Most importantly, the labor markets appear unfazed by last year’s angst. Businesses continued to add to staffs at a modest but steady pace, even though capital spending plans went on strike. Deleveraging continues, but consumers continue to advance their expenditures and savings supported by easing financial conditions, low interest rates and quiescent inflation. As long as this remains the case, the recovery will remain in train. I believe growth will be shallow in the first half (0.5% to 1.0%) and then will pick up some in the second half (2% +), but average 1% to 2% for the full year.
But all is not yet settled. At a minimum, we know what our tax rates will be this year and that they are permanent. But the fiscal deal only put off the harder decisions on the spending side of the equation which will occur in the not too distant future. Those automatic spending cuts, known as the sequester, have been put off until March and will coincide with a potentially an epic battle on the debt ceiling increase. As a result, a large chunk of the fiscal adjustment remains in limbo for the next two months. Avoiding these cuts will mean finding more revenue or abandoning any resolve for deficit reduction. No action will mean the sequester will go into effect on March 1, with an added drag of 0.5% to growth—or not should the can be kicked again down the road. And the dire debt-to-GDP math has not shifted in any way. In a small act of solace, the deal also canceled a 0.5% increase in congressional salaries. Imagine the public foment if that had not been reversed.
The recent drama was a most ugly way to run a country. After a toxic public debate replete with soured relationships and name calling, where are we? A bigger tax bite for the wealthy and for working Americans—check. A permanent patch for the AMT and a temporary extension of unemployment benefits—check. Meaningful action to remedy humongous deficits and debt—no. Averting a credit downgrade from the rating agencies—no. Avoiding another debt ceiling showdown—no. Has uncertainty been removed—no, only partially deferred, although the markets are cheering.
The agreement achieved the bare minimum, and the saga is not yet over. The next battle on the debt ceiling increase will be tied to spending cuts, and the heat on these issues will begin in February. President Obama has made clear the price of any future spending cuts or entitlement reform will require more tax increases, likely via tax reforms to reduce deductions and tax expenditures, and that he will not negotiate on the debt ceiling. A game of chicken involving the debt ceiling will be a re-test of the Treasury’s cash management operations (this time without Geithner) and will likely re-introduce uncertainty to financial markets and likely weigh on business and consumer sentiment.
Intuitively, ongoing deficits are really future taxes, since they will need to be paid for at some point. In the end, the only way to cut deficits is to raise taxes, reduce spending or speed up economic growth. The two former actions tend to depress the latter. With taxes already hiked, the next iteration will involve some spending cuts. But it seems no one will admit that maintaining our social welfare and entitlement system will require more taxes, not just on the rich but also on the middle class. So we may be facing an arduous and ongoing situation of step-like austerity, with lawmakers arguing and adjusting the spending and revenue dials slowly over months and years without a major fiscal policy shock but with an ongoing drag to growth. The lack of market pressure together with a gridlocked and dysfunctional government unwilling to address the medium term fiscal challenges means we should set our expectations low for any grand bargain.