BEN Bernanke, chairman of the Federal Reserve, is not known for his turns of phrase. Nonetheless, "fiscal cliff" — the term he coined to describe the tax increases and spending cuts that will hit America’s economy at the start of 2013 unless politicians agree to avert them — has inspired songs and television comedy.
"The fiscal cliff is a danger zone/It’s where grown men go when budgets are blown," croons musical satirist Merle Hazard, while Jon Stewart’s The Daily Show calls the prospective disaster "Cliffpocalypsemageddonacaust."
There also have been more serious consequences. The shadow of the fiscal cliff has depressed corporate investment. American consumer confidence has started to wobble. Growth is slowing, perhaps to as little as one per cent in the fourth quarter. Policymakers around the world are fretting: Australia’s central bank recently cut rates, citing the cliff as a worry.
These worries are understandable but overblown. In the short term the risk of economic catastrophe is minimal. The real threat, and the real opportunity for President Barack Obama, lies in the medium and long term.
If lawmakers do nothing, America faces fiscal tightening in 2013 worth as much as five per cent of GDP. That is a Greek-scale squeeze. It would not take many months for it to push the country into recession. A complete standoff between Obama and Congressional Republicans would lead to disaster even sooner, because unless America’s lawmakers vote to increase the "debt ceiling" — the maximal amount of debt that the Treasury can issue — by around March, the federal government will be unable to pay its bills, including potentially its bondholders. The damage from a self-induced default would dwarf even that from the fiscal cliff.
Precisely because the consequences of prolonged stalemate would be so disastrous, however, there almost certainly will not be one. Either toward the end of December or early in 2013, Obama and the Republicans are likely to reach an agreement that avoids most of the tax increases, ducks most of the spending cuts and raises the debt ceiling.
Elements of that deal are becoming a little clearer: The Republicans seem to have given in to Obama and accepted that wealthier Americans will have to pay more tax, probably through both limited deductions and higher tax rates.
There are still two big reasons for America, and the rest of the world, to worry, however.
First, depending on the details of the deal, there could still be too great a fiscal squeeze in 2013.
Second, and more important, entitlement spending is America’s biggest long-term fiscal challenge. Any fiscal deal must reform Social Security, Medicare and Medicaid. Obama has been demanding tax increases of $1.6 trillion during the next 10 years, but has offered entitlement cuts of only some $400 billion. He needs to increase the latter, to entice the Republicans into a deal and because it is the right thing to do.
America has a chance to straighten out not only its finances, but also the highly polarized politics that underpin them. Republicans believe passionately that higher taxes will wreck the economy. No Republican in Congress has voted for higher income taxes since 1990. Democrats believe, equally passionately, in the sanctity of health-care and Social Security plans for the old.
The last time Social Security was overhauled was in 1983. Since then politicians have added handouts, even as medical costs have soared and the population has aged. The result is a gaping, and growing, fiscal hole. America’s underlying "structural" budget deficit is almost seven per cent of GDP. Among rich countries, only Japan’s is bigger.
Since the financial crisis, America’s ideological standoff has, as it happens, produced sensible short-term fiscal policy. The United States cushioned its recession with stimulus and, by keeping fiscal policy loose, has supported the recovery. With many other rich countries tightening further and faster, that did the world a service.
In today’s weak recovery the same logic holds. With bond yields near record lows, America need not, and should not, tighten policy too fast. Some tightening in 2013 is both expected and manageable. Most forecasters expect around 1.5 per cent of GDP to be trimmed as measures that were always designed to be temporary, such as the payroll-tax cut, expire.
There is a danger, however, that a minimalist deal would result in too big a squeeze. An agreement that extended tax cuts only for the middle class, for instance, would imply a tightening of some three per cent of GDP in 2013. That is too fast.
To preserve the recovery, a deal must be less draconian. It should focus on long-term entitlement reform rather than short-term cuts. That is good politics, since overhauling entitlements is a Republican priority. It also is good economics.
Spending on the old will rise faster in America than in most other rich countries. That is partly because Europe’s austerity plans have already delivered some fairly tough pension reforms, but mainly because America’s health-care costs are so high and are rising so fast. Obama has the opportunity to fix this and to reform entitlements, something that has eluded every president since Ronald Reagan. The combination of his re-election and the fiscal cliff has forced the Republicans to show some flexibility on increasing the tax take. That victory has given Obama leverage with the left of his own party. If he uses it to force real change, from lower indexation of Social Security payments to tougher means-testing of health-care benefits, he will transform America’s long-term fiscal outlook.
So far the president has shown lamentably little boldness, arguing that Social Security should not be part of any deal and that health-care costs can be controlled by reducing payments to providers such as hospitals, as opposed to cutting benefits.
In private things may be different. Obama is said to want a comprehensive deal that not only averts the fiscal cliff but also sets America on a sustainable fiscal course.
Such a deal is within his reach. He should grasp it