Negotiations to avert the Fiscal Cliff offer great political drama, but they won’t solve Washington’s budget woes and may cast the nation into another recession or worse.
The Budget Act of 2011 requires the president and Congress to agree on a nine-year $1.2 trillion deficit reduction program, or cuts in annual defense and non-entitlement outlays each equal to 54.7 billion trigger on January 1. Simultaneously, the Bush Tax cuts, the 2 percentage point payroll tax holiday, and other assorted programs expire.
Altogether, $136 billion in annual spending reductions and $532 billion in additional taxes could trigger cataclysmic consequences for the economy. Unemployment would rocket past 15 percent, state government finances would collapse, homeowners would default on mortgages, and hundreds of banks would fail.
To avoid calamity, President Obama and House Republicans will likely agree to raise taxes on high income Americans by $100 to $150 billion and curb spending by an equal amount. However, those efforts will prove too little, and yet, the economy may still skid into recession—depriving the federal government of tax revenues and further pushing up the budget gap.
The federal deficit exceeds $1 trillion dollars—up from $161 billion in 2007, the last year before the financial collapse. Spending is up some $1 trillion, as outlays for Social Security, Medicare, Medicaid and other entitlements have increased by an amount equal to the entire 2013 defense budget.
By the end of the decade, runaway entitlement spending will require shutting down the military or crippling many other domestic spending programs to head off ballooning deficits.
With Americans living longer, the only reasonable solution is to raise the Social Security retirement age to 70, and pattern US health care reforms after other national systems that better contain costs.
The Germans and Dutch spend one-third less on health care than the United States, because their governments more aggressively regulate prices, better ration care, and spend less on law suits.
Democrats, hamstrung by unions, are loath to require Americans to work longer, and are too beholden to tort lawyers and the medical establishment for campaign support—hence, ObamaCare just throws more money into a broken system.
Republicans refuse to admit more competition—we already have plenty of it among providers, drug and device manufacturers and insurance companies—won’t adequately slow rocketing health care costs.
Over the next decade, without a significantly higher retirement age, effective price controls in health care and torts reform, federal spending and the national debt will jet into the stratosphere. Mounting interest payments, investor reluctance to buy US Treasurys, and consequent draconian cuts in spending will thrust the United States into the crisis now gripping Greece and Spain.
More immediately, even modest tax increases and spending cuts threaten a second recession, because President Obama and Congress failed to address dysfunctions that created the bubble and bust of the 2000s and make the economy perilously dependent on deficit spending.
From 2001 to 2005, the trade deficit doubled to more than $700 billion, thanks to subsidized imports from China, restrictions on US sales into the Middle Kingdom and rising oil prices. This resulting loss of demand for US-made goods and services should have instigated a recession; however, Chinese and Middle East oil exporters stepped up purchases of US securities, and those helped finance questionable mortgages, car loans and credit card debt. Americans spent more than they earned and the boom continued into 2007. When homeowners and other borrowers could no longer service their debts, defaults and bankruptcies resulted and the economy crashed.
A huge trade deficit with China and on oil continues, but now the federal government is doing the extra spending and borrowing for us. If budget negotiations slice $200 to $300 billion off the deficit, as is likely, GDP will contract $350 to 500 billion and unemployment will rise above 10 percent.
President Obama and House Republicans indicate no interest in genuinely confronting Beijing to force a more equitable trading relationship with the Middle Kingdom.
Slashing oil imports requires the President to permit more drilling in the Gulf, off the Atlantic and Pacific coasts and in Alaska, and for Republicans to embrace alternative energy sources and more aggressive conservation measures.
Neither seems likely.
All told, absent major changes in trade and energy policies to boost domestic demand and growth, budget deficit reduction is not possible without another long, hard recession. And absent genuine deficit reduction, the country is headed for economic chaos by the end of the decade.
Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and widely published columnist. He is the five time winner of the MarketWatch best forecaster award. Follow him on Twitter @PMorici1.