Kicking a “bigger can” down the road.

December 15, 2010

While the fiscal bargain has removed some near term fiscal uncertainty it has

greatly increased medium and long term uncertainty. Politicians keep kicking an

ever bigger can down the road, as the list of temporary fiscal stimulus actions

continues to grow. This adds unnecessarily to economic uncertainty and makes it

difficult not just for economists to forecast, but for businesses and individuals to

plan for the future. Here are our thoughts on how fiscal policy will evolve over the

next two years.

While the old Congress will continue to add to the deficit through the end of 2010; most Republicans ran on a fiscal austerity platform: their “Pledge to America” included a promise to

cut spending by $100bn. Our expectation is that there will be only small spending

cuts in the next two years as the Democrats strongly resist deep spending cuts

and Republicans remain reluctant to cut popular programs.

The most likely vehicle for spending cuts is negotiations around raising the debt

ceiling. By March the federal budget will run up against limits on debt issuance

and absent new legislation, the government will have to stop borrowing and

gradually shut down. In 1995-6, the Newt Gingrich-led congress shut down nonessential

government for a total of about four weeks. While each party blamed the

other for the shutdown, public opinion sided with President Clinton, boosting his

popularity and helping his re-election in 1996. This time around, with a much

higher deficit we think the Republicans will be able to extract some small

concessions.

Both the 2pp payroll tax holiday and extended unemployment benefits expire at

the end of 2011. Together they provide about a $175 bn per year boost to

household disposable income--$120bn from the tax holiday and $55bn from the

unemployment benefits. We think there is about a 50% propensity to consume

out of the temporary payroll tax cut and a 100% propensity to consume out of

unemployment benefits. Hence if they are allowed to expire there would be a

$105bn shock to spending, cutting GDP growth by about 0.7pp.

While expiration is a significant risk, we suspect that at this stage there would be another Faustian bargain where Democrats get another one-year extension of unemployment benefits and Republicans get a one-year extension of the payroll tax cut.

All of this suggests a huge challenge for the lame duck government after the 2012

election. If our scenarios above are right, this time there would be more than

$400bn in temporary programs set to expire at the end of 2012. This time the

incentives to cooperate will be different.

Two scenarios seem most plausible to us.

1. If the unemployment rate has fallen significantly, we would expect

Democrats to do well and Obama have a good chance to be re-elected. Since he

would not face re-election in 2016, we would expect him to be much less likely to

capitulate to the Republicans and both insist on and get a rise in upper income

tax rates.

2. On the other hand, if the job market remains depressed and

Republicans capture the White House we would expect some spending cuts

under a new, more conservative government.

Either way we would expect modest fiscal consolidation in 2013.

This information is courtesy of our friends at Bank of America, Merrill Lynch