Benjamin Studebaker

Rumour has it the republicans have given Obama an offer to avert the fiscal cliff, the combination of deep, immediate spending cuts and tax increases that the CBO predicts would send the country into a new recession. The offer gives Obama something he cannot get without a deal–most notably, an extension of emergency unemployment benefits. The offer comes at a cost, however. In exchange, the republicans demand a small but painful cut in social security benefits.

I want to investigate whether or not this deal is worth taking. From Obama’s perspective, on the one hand, there’s what he can get if he doesn’t take the deal–after January 1st, tax rates will go up on everyone, and he will be able to make the republicans vote for a tax cut for the middle class, because voting against tax cuts (except for payroll tax cuts) is against their anti-tax pledge. Plus, the polls show that the republicans will be blamed if we go over the cliff, so Obama might have more leverage after the 1st to get more or better concessions. On the other hand, there are certain elements to the offer in front of him that he might otherwise never get. To simplify this, here’s an Venn diagram. In blue are things that make Obama smile, in red are things that make Obama frown:

Now, there are a few things to note about the size and scale of these various things:

• The infrastructure spending and the unemployment benefit combine for just 0.5% of GDP. As stimulus goes, they’re pretty small, but if you’re unemployed, they’re important.
• The social security cut isn’t huge, but seniors will feel it. A senior who retires at 65 will see 3% lower benefit at age 75 and 6% lower benefit at age 85 under the republican proposal, which changes the inflation index used to measure social security payout to one that favours seniors less (from regular CPI to chained CPI). It hurts seniors and doesn’t save a lot of money.

But is Obama necessarily looking at this situation the right way? I’m not so sure.

This comes down to whether you’re more concerned with anemic US growth and high unemployment or debt and deficits. If unemployment is still too high and growth is still too low, then the goal of our policy should be one of stimulus, to lower the former and raise the latter. Stimulus entails lower taxes and higher spending. If debt and deficits are the concern, austerity is the answer, and revenue should rise while entitlement spending falls. Interestingly, the democrats and republicans do not align with either of these logical positions. Logically either you should be:

1. Pro-stimulus: Revenue should fall; spending should rise. Big debt and deficits, better growth and unemployment.
2. Pro-austerity: Revenue should rise; spending should fall. Small debt and deficits, worse growth and unemployment.

In contrast, we have these political positions:

1. Democrats: Revenue should rise; spending should rise. Incongruous and contradictory.
2. Republicans: Revenue should fall, spending should fall. Incongruous and contradictory.

This is because the debate in congress is not really one of “what’s good for the economy”, it’s one of “how big should government be?”. This latter question is a red herring; it only serves to distract us from solving this particular problem. In the long term, debt and deficits will be a problem as health care costs continue to rise and strain the American state. In the short term, however, unemployment is still high, growth is still low, and austerity now will worsen both of these conditions. The two parties are not at present prepared to offer a comprehensive approach either to tackle debt and deficits or to tackle growth and unemployment. Instead, they’re engaging in a convoluted discussion that accomplishes neither goal efficiently. If we care about debt and deficits, then the republicans are right to demand spending cuts, but the democrats are right to demand tax increases. If we care about growth and unemployment, then the republicans are right to demand tax cuts, but the democrats are right to demand spending increases.

Which one should we care more about? My verdict is growth and unemployment. Why?

The goal with debt and deficits is to maintain a constant, sustainable amount of debt as a percentage of your country’s GDP, so as to maintain investor confidence. The US government can sustain, at normal growth rates, a $400 billion deficit. This means that there’s $700 billion to account for. However, despite this, investor confidence is not an emergency–investors still lend the government money at near-record low rates because the rest of the economy is such a minefield that they are scared to stick their incomes anywhere else:

So, for whatever reason, investors are giving the government quite a bit of time to deal with this issue. Why are they doing this, when the current deficit is $700 billion south of sustainable?

The reason is that quite a bit of the deficit will self-correct if growth and unemployment improve. Krugman points out several reasons for this:

1. As per the CBO, Potential GDP is higher than actual GDP. This means potential revenue is higher than actual revenue. In addition, the various stimulus measures designed to soften the blow of the recession have the government taking a smaller percentage of revenue than normal. With an economy running at its potential and revenues raised back to normal as a result, the state would take in an additional $450-500 billion. This cuts the debt and deficit gap to $200-250 billion.
2. In addition, most of the spending increase in recent years has been spending for programmes to relieve those negatively impacted by the recession–Medicaid, Unemployment Benefit, and so on. This accounts for between $150 and $250 billion, meaning that the true gap between the deficit and something we can sustain in the long term is no larger than $100 billion.

How do we know #2 is true? We look at spending on programmes that aid the poor:

These shot up during the recession, and are beginning to slide back downward as things improve.

What this means is that, by focusing on growth and unemployment now, we can make tremendous progress on debt and deficits in the long term even if, in the short term, we’re spending more and taxing less. The proposal on offer doesn’t really accomplish that objective, but nor does Obama’s plan, really. So what should we do?

We should:

1. Follow the democrats and extend unemployment benefits, the payroll tax cut, increase spending on infrastructure, and pass that old Obama jobs bill right now.
2. Follow the republicans and keep the Bush tax cuts for another year and avoid raising capital gains tax, tax on dividends, or cap deductions at any given percentage.

We should do this until unemployment is below 6.5% (it’s presently at 7.9%) and the economy is running more or less at potential. Then we should look at the deficit and see how much larger than $400 billion it is, and make the requisite adjustments. What I suspect we will find is that these adjustments can be made in the short term with only a portion of the tax hikes the republicans are presently offering to concede on. You can call this the Studebaker Compromise, though I very much doubt anyone goes for it.

In the long run, the country still needs to do something about health care costs to prevent debt and deficits from rising. Ten years from now, we will likely find that health care costs are presenting our budget with quite monstrous challenges otherwise. But making those changes does not entail any of these policies, all of which are, in comparison, band-aids. True health care reform, on a scale that dwarfs Obamacare, will be necessary to reign in those oncoming expenses.