FPAS Article – The Ceiling and the Cliff

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Where Should the Can be Headed?
Ever since the historical US’s AAA rating cut by S&P in Aug 2011, investors have been befuddled with a global investment market driven largely by incessant political waggling and confusing economic jargons. In a bid to stem further raising of the US “debt ceiling”, the Budget Control Act required a bi-partisan “supercommittee” to be formed to work out a $1.2 trillion deficit reduction over 10 years, in order to rebalance the US’s fiscal budget. A year later, the term “fiscal cliff” was introduced. What does it all means?
Simplifying the Jargons…
a. Fiscal cliff
In economics 101, a government runs its budget by increasing or reducing tax (income) and public spending (expenditure) levels. We all know that the US is in debt as it spends more (from 2 major wars and rescue packages) than it generates tax revenue (from two major recessions following 9/11 and subprime/financial in 2008). Earlier in 2012, the Congressional Budget Office (CBO) in US forecasted that the US will experience a sharp reduction in its budget deficit due to a simultaneous expiration of a Bush-era tax break (increase tax revenue) and an automatic government spending cut (also known as “sequester”) from 2 Jan 2013 as a circuit breaker to its rising debt woes. The twin fiscal policies of spending cut and tax hike resulted in a steep slope in budget reduction (see Figure 1) and hence the term “fiscal cliff”.

 

Figure 1: Projection of US’s deficit from 2012 to 2022

Before you think that a deficit reduction is always good (and cheer), it would spell doom for millions of Americans laid off from government jobs and still be liable for high taxes, bringing the US to economic free-fall.
b. Debt Ceiling
Economics 101: What happened when you run into budgetary deficit? You print money (if you can) or borrow. The formal is a monetary policy that may run into dangers of inflation and currency devaluation and is less effective to solve a fiscal problem. Borrowing or issuing public debt supported by a tax system is often preferred.
Debt existed in the US even before its founding in 1776, when some of the founding fathers borrowed money from France and Netherlands to finance the American Revolutionary War. By the end of the War in 1783, US debt was at $43m. Since then, domestic debt has been so ingrained in the US’s DNA to fund its national objectives that it ballooned. The first “ceiling” or total aggregate limit across all federal debts was established in 1939, and had since been raised 94 times at $16.4 trillion as of Jan 2013.
There are two interesting observations about the US debt ceiling if we haven’t known: first, US and Denmark are the only 2 countries in the world with a debt ceiling; second, the debt position does not limit or control the ability of the government to run budgetary deficits or spend more than tax receipts and it has become a formality to raise them. The need – or redundancy – of a debt ceiling is therefore questionable. A more important indicator of fiscal health that economists debate on could be the debt-to-GDP ratio, if there should be a “red line” or dangerous level beyond which funding the interest repayment from tax income may become unsustainable.
What “Kicking the Can down the Road” really means?
On average, the US economy has to raise an additional $120 billion from tax income, or cut a further $120 billion government spending. The Democrats favors raising the tax rate of the wealthy; the Republican presses for spending cuts from national programs. In Figure 1, if the “baseline fiscal cliff scenario” is allowed to happen, including the much-dread “sequester”, the GDP growth is expected to shrink by 2/3 this year and unemployment rate to jump from 7.6% to 9.1% , not to mention a significant impact on the US military and defense capability. Not a pretty picture for both Republican and Democrats.
However, the Congressional Budget Office also projected that if the tax and spending policies can be extended (“alternative fiscal scenario”), the cliff would flatten to a plateau. The US averts a double-dip recession and possibly maintains its recovery trajectory, but funding the prolonged deficit would bring the debt level from 58.5% GDP to 89.7% GDP in 10 years time. Under a even longer term projection, if the “fiscal cliff” is allowed to happen in its original form, the debt would come to just 1% GDP in 25 year time but under the “extended alternative fiscal scenario”, the debt level would soar to 199% GDP, equivalent to that of Japan’s!
This “damn if you do [cut spending], damn if you don’t [default payment]” situation is the reason why the Democrats and Republicans have to settle for a compromise. The 11th hour signing of the American Taxpayer Relief Act supposedly increase tax receipts slightly from the $400k income group and pushing back the “sequester” to 1st Mar 2013. Then on 23rd Jan 2013, another bill was passed to suspend the debt ceiling (and consequently “sequester”) until mid-May, essentially allowing more money to be borrowed to avert government shutdown and default and buying more time for the “supercommittee”.
Once again, the US has defused both of the fiscal cliff and debt ceiling time bombs by deferring the crisis rather than solving them (like in 2011), what observers famously call as ‘kicking the can down the road’. The more important question is: are they kicking the can towards the right direction?

 

By Derek Liang,
Affiliate of STEP™, CFP ®, B.Eng(1st class Hons)
Derek.liang@finexis.com.sg

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