One cliff at a time

John Boehner

American politicians have not disappointed. After creating the fiscal cliff themselves, they proved incapable of avoiding it entirely and have set themselves up for another round of gruelling negotiations on raising the debt ceiling and replacing the sequester (across the board spending cuts worth $110 billion per year) pretty much as soon as the current deal is signed into law. This latest law jewel emanating from a dysfunctional Congress extends the Bush tax cuts for individuals and couples earning less than $400,000 and $450,000, respectively. Above that threshold the marginal rate will rise from 35% to 39.6%. Inheritance taxes will go up from 35% to 40% after the first $5m for individuals and $10m for couples, whilst taxes on capital gains and dividends will rise to 20% from the current 15%. The enhanced unemployment benefits affecting some two million people will be extended for another year whilst the tax credits for poorer and middle-class families have been extended for another five years.

Lawmakers have not exceeded our expectations then. The deal does nothing to address the spending cuts, which have been delayed for a few months, and the debt ceiling, which the Treasury reached on Monday (although it still has some wiggle room to allow it to borrow for another two months). Furthermore, the payroll-tax cut was allowed to expire as scheduled meaning that workers’ purchasing power will decrease by about $1,000 each, causing a significant drag on the economy. Entitlements, which many analysts agree will be a key driver of the burgeoning US debt in the future, have not been tackled although they will probably become a sticking point in the next negotiations as Republicans will demand cuts to them as a price for raising the debt ceiling. Given that they won not a single spending cut in the latest round and backed down on increasing taxes for the rich, they will most likely not be enthused by a sincere spirit of cooperation in the next round. 

President Obama, for his part, has not hesitated to brandish this deal as a Democrat victory and set a worryingly belligerent tone for the next round of negotiations by claiming that “If Republicans think that I will finish the job of deficit reduction through spending cuts alone…they’ve got another thing coming.” His key request that taxes should go up on the rich always made more political than economic sense: higher taxes for the rich should raise about $600 billion over a period of ten years against a projected deficit of $10 trillion over the same period. In other words, pocket change. But it does chime in well with the public sentiment that the rich have weathered the crisis at the expense of the poor and now need to pay their dues. It also goes some way towards appeasing those on the left who perceive Mr. Obama as too often caving in to the demands of the Republicans on protecting the rich. Unfortunately, it does not foster bipartisan cooperation (something Mr. Obama had campaigned on) and basking in symbolic political victories should not come at the price of achieving significant economic ones for the good of the country. Given the unlikelihood of either side steering clear from ideological battles and the fractured chaos of the G.O.P., let us see what deal an ineffective Congress can rustle up next.

Who's the chicken?

From: DonkeyHotey

The world waits with bated breath for an outcome of the ongoing fiscal cliff talks in Washington with much the same anticipation that accompanied the end of the Mayan calendar on December 21. As it happened the end of the world was not to be, and sadly, a grand bargain on how to tackle America’s sickly finances may not grace the news headlines either. There will in all probability be a last minute deal, a fudge of sorts that merely postpones a long-term solution to America’s burgeoning debt.

Back in 2011, the Obama administration came to blows with the Republicans on raising the debt ceiling for the US government and as part of the compromise that broke the impasse both parties agreed to point a gun to their foreheads to ensure a long-term solution was agreed on by the end of this year. This gun is the so-called fiscal cliff: a combination of draconian tax increases and spending cuts worth about 5% of GDP over a year that would kick in on January 2^nd and are likely to topple America’s fragile economy back into recession. No one in their right minds would contemplate rolling out such a harsh package at this stage of the American recovery, and indeed the whole world (American politicians included) assumed the fiscal cliff would be enough to ensure a deal is passed in Washington. The question now is what kind of deal.

Initially Mr Obama had pushed for a rise in tax rates for those earning over $250,000 a year, subsequently rising that threshold to $400,000. He has also agreed to change the way Social Security benefits are indexed to inflation and called for a two-year extension of the debt ceiling. For his part John Boehner, the Republican speaker of the House of Representatives, has also made some concessions. He had conceded that tax rates could rise for those earning over $1m a year and the revenue he is prepared to see gathered over ten years now stands at $1 trillion.  However the suicidal polarisation of US politics makes any reasonable deal unpalatable to one or both of the parties.

The concession to allow the Bush-era tax cuts to expire for those earning over $1m a year came under Mr Boehner’s Plan B, which still left a fiscal tightening of nearly 3% of GDP over a year. As it happens even this largely symbolic tax rise (the Americans affected by it number about 400,000, or 0.3% of tax filers) was anathema to the fiscal hawks in the G.O.P. and so they promptly proceeded to reject it.

The odds now seem to be in Mr Obama’s favour. Whilst a grand bargain which involves a package of spending cuts and tax rises worth at least 2% of GDP to stabilise the debt level is not likely to emerge from the last-ditch negotiations going on right now, the G.O.P. has manoeuvred itself into a corner. Mr Obama’s fall-back position involves a minimalist bill that would prevent an income tax rise on the middle class and extends vital unemployment insurance for Americans looking for a job. If Republicans voted against this for whatever ideological reasons, they would essentially be voting for a tax rise on ordinary Americans. Given that recent polls have found that 53% of Americans would blame the Republicans if the country toppled over the cliff, it is a powerful incentive for them to compromise to avoid becoming the subject of public opprobrium and being eternally branded as the party of the rich as the whole country reels back into recession.

Unfortunately the deadlock is not just about economics. November’s election painted a dreary picture in terms of the polarisation of the country. The number of states that was decided marginally, i.e. by five percentage points or less, decreased from six to four, meaning that incumbents have safer seats and can ignore the needs of the country in favour of their constituents. More worryingly however is the fact that these seats may be safe from the rival party, but, especially for the Republicans, they dramatically increase the battles at the primaries. To vote for a tax rise now would be for many Republicans analogous to committing political suicide. Of course there are moderates within the G.O.P., and both their political futures and the passing of a deal on the fiscal cliff rest on them being able to form a large enough block to give them political cover. The ideological polarisation within the G.O.P. therefore matches that of the entire country, and the repercussions of such a divide are crucial not just for the fiscal cliff but for the other items on Obama’s agenda, such as climate change and gun control.

Whatever final deal emerges then, it will most probably not be a definitive one for the deficit but it will give us a clue as to the turn American politics will be taking. As ever, it’s not just the economy, stupid.

The Euro: What to Do?

Yet another summit, yet another vague plan. France’s finance minister Francois Baroin said the EU summit due to be held later this month will agree “decisive” measures to tackle the crisis that is engulfing the euro zone. “Decisive” however, does not seem like the right word to use after European politicians delayed the disbursement of the next €8bn tranche of the rescue package for Greece until November, thereby disseminating even more uncertainty in the markets. Furthermore, all the public talk about a possible further restructuring of Greek debt has done precious little to soothe investors’ frazzled nerves.

The decision to postpone the next disbursement of money is the least of problems however, and was probably taken in an attempt to push Athens into further reforms as there are no big bond payments due in the next weeks. The medium and long-term decisions are the ones that European leaders are proving unbelievably loath to take, such as agreeing on a partial write-down of Greece’s debts, recapitalising European banks and bolstering the European Financial Stability Facility (EFSF). Yet everyone seems in agreement that the more European leaders prevaricate, the more entrenched and harder to resolve the crisis becomes.

Most experts agree that some kind of haircut on Greek bonds is necessary, as long as it is combined with bank recapitalisation and a significant increase in the size of the EFSF. In July, European leaders had suggested a voluntary debt restructuring on the part of private banks coupled with fresh inflows of official money, but both The Economist and Martin Wolf from the Financial Times argue that the deal fell short of helping Greece whilst providing excessive relief to the banks. Raoul Ruparel of Open Europe, a think tank, claims that around 50% of Greek debt ought to be restructured and that European banks ought to be able to weather the ensuing storm thanks to a recapitalisation program through the EFSF. However, the European Central Bank (ECB) has long been adamantly opposed to any form of write-down which also raises implications for how exactly the EFSF would be able to build a firewall around endangered economies Italy and Spain without ECB funding. Gavyn Davies, writing on the Financial Times, explains that in order for Greece to reach an ambitious debt target of 80% of GDP by 2016, the rescue package would have to amount to €200bn. A 50% haircut on Greek debt that is held in private hands and which currently amounts to €240bn would thus raise €120bn, which still leaves a hole of €80bn. Furthermore, it is highly unlikely that the 50% haircut could be implemented voluntarily, thus raising the spectre of a technical default which is anathema to the ECB.

A corollary of the debt write-down is the problem of banking liquidity (or lack of it). Martin Wolf explains that the debt overhang impairs both solvency and liquidity in the banking sector, and proposes financing through capital injections and central bank support as the solution. However, as Gavyn Davies rightly points out, the amount of recapitalisation needed depends on the size of the write-downs on Greek debt and on the market’s expectations of possible future write-downs on other sovereign debt because of a loss of confidence. This is why it is absolutely vital to protect Italy and Spain from being engulfed in the crisis by putting Europe’s banking sector on sound footing. George Magnus, a senior economic adviser at UBS Investment Bank, believes that the ECB ought to be prepared to stand by and buy any amount of Spanish and Italian bonds to prevent banking contagion.

Unfortunately, the need to build a firewall around Italy and Spain entails a bolstering of the EFSF, which at its current €440bn capacity, is insufficient to ring-fence the crisis. Policy-makers have been bending over backwards to get around the ECB’s unwillingness to buy struggling economies’ bonds and to lend to the EFSF, touting various ideas which involve borrowing from public institutions that already have a banking license and that therefore have access to ECB funding. Another option would be for the EFSF to guarantee the first 20% loss on any new bonds issued by ailing countries; it would be able to implement this without requiring money from the ECB but the prospect of a bank recapitalisation will sharply deplete its reserves rendering this harder. Gavyn Davies argues that the EFSF however could use its remaining capital, estimated at €200bn after various rescue packages and possible recapitalisation programmes, to insure about €1000bn bond purchases in Spain and Italy which would cover their bond issuances for the next three years. This would soothe markets’ nerves and more importantly, buy European leaders a window frame in which they could tackle the euro zone’s underlying problems, namely lack of competitiveness and growth in the periphery countries.

Fostering growth in Greece and its neighbours is a daunting task, to say the least. Yet without growth the debt burden will linger on, as Vicky Pryce, senior managing director of economics at FTI Consulting, has said. The fiscal austerity to which Europeans have been adhering so zealously is only one side of the coin and does not solve the structural problems that affect the Mediterranean countries. One need only to look at the ominous slashing of growth forecasts in the United Kingdom, which has embarked on an audacious deficit reduction programme, to see how austerity can tighten the tap of an economy reducing it to a mere trickle. Christopher Smallwood, writing for Lombard Street Research, claims that the Club Med will restore competitiveness by falling wages and mass layoffs, both of which are likely to have extremely painful repercussions. External financing may mitigate the shock but will also have the corollary effect of slowing down the adjustment process. Furthermore, Martin Wolf points out that if external deficits are to fall in Greece and its neighbours, then surpluses must fall in other countries, notably Germany. Yet discussion on this aspect has been conspicuously absent. The quagmire in which the euro zone finds itself then, is only the beginning of a very long and tortuous process to address the fundamental imbalances within it which were disastrously overlooked in its inception.