Lloyd Blankfein and Erskine Bowles Agree: The American Economy is Nearing a Big Cliff

Yesterday, Erskine Bowles, co-chairman of President Obama’s National Commission on Fiscal Responsibility; former Sen. Alan Simpson, the other co-chair; and Lloyd Blankfein, CEO of Goldman Sachs discussed the impending fiscal cliff confronting our nation on CNBC. All three men agreed that America was heading towards a fiscal disaster and no one in Washington is doing anything to avert a crisis.

Given that the Budget Control Act of 2011 takes effect on December 31, 2012, before the newly elected president’s term begins, it is imperative that Congress begins deliberations immediately.

It would be useful to define “fiscal cliff” to facilitate a debate about how it can be rectified. It is a “conundrum that the U.S. government will face at the end of 2012 ...” At midnight, on the last day of the year, the temporary payroll tax cut will expire resulting in a 2 percentage point increase for workers. Certain tax breaks for businesses will end. The Alternative Minimum Tax will create higher income taxes for millions of Americans. Bush’s tax cuts will end and resort back to rates during the Clinton administration for everyone. And, taxes related to the president’s health care reform would go into effect. Simultaneously, spending cuts agreed upon last year during the debt ceiling negotiations must be made. Analysts predict that 1,000 government programs, including defense and entitlements, will experience “deep, automatic cuts.”

Congress has three options:

1. It can allow the aforementioned to occur. This strategy will have a devastating impact on the economy, but the deficit, as a percentage of GDP, would be halved.

2. It can cancel part or all of the scheduled tax increases and spending cuts, which would deepen the nation’s debt problem.

3. It can take actions somewhere in between 1 and 2.

Averting the fiscal cliff will be a very difficult endeavor, given the partisanship in Washington. Several previous efforts were unsuccessful. The sides are torn between the amount of spending cuts (Republican objective) and tax increases on the wealthy (Democrat objective) that should be implemented. Since we are in an election year, compromise will not happen before the new president is declared leaving a short time for action. The most likely outcome will be another stopgap measure that extends the debt ceiling for a few months and defers all of the tax increases and Draconian spending cuts.

The Congressional Budget Office has stated that the current laws slated for 2013 would reduce the deficit by $560 billion. But, gross domestic product would decline by four percentage points in 2013; and, a recession would ensue. Unemployment would rise by one point, a loss of two million jobs.

One of the main elements of the fiscal cliff is the sequester, the automatic spending cuts in the Budget Control Act that total $1.2 trillion beginning in 2013 and occur over nine years. The cuts are split between defense (wars are exempted) and domestic spending (Social Security and Medicare are exempted).

The sequester causes pain for both sides. Legislators do not have any power to change the cuts. They are intended to impact all programs equally. “The indiscriminate pain is meant to pressure legislators into making a budget deal to avoid the cuts.” It is a sad commentary that our Congress must force itself to compromise with such an unconventional arrangement.

The response from those who would be impacted by the cuts has been totally predictable. Everyone’s agenda is the “most important.” Defense hawks say our nation’s readiness will be dramatically affected. Social agitators say children and single moms will go hungry. Both are exaggerations that have impeded any progress getting this country back on track. The fact is that both of these areas could stand to cut out some fat as part of a grand compromise.

The debt ceiling is another issue. It must be increased to allay the concerns of the rating agencies; they determine the debt rating of U.S. securities, which in turn affects the availability of funding and its cost. Since the nation is operating in a deficit, all amounts above receipts from taxes and the like must be funded with new borrowings. If the federal government cannot borrow, the problem is obvious.

The Bush-ear tax cuts are another important element of this whole discussion. Just after George W. Bush was elected president in 2000, Congress passed tax cuts proposed by the president. The cuts were supposed to be a precursor to tax reform, so they were passed with an expiration date of 2010. Ten years should have been plenty of time to enact new tax laws.

The political landscape became complex as power shifted in Congress; the result was no tax reform and the specter of a reinstatement of higher tax rates in 2010 for all Americans.

To make a long story short, Republicans are anathema to any tax increases, including those affecting the wealthy. Correspondingly, Obama called for reinstatement of earlier tax rates for those earning more than $250,000. Last year, the president and Congress agreed to kick the can down the road to December 31 by extending all of the tax cuts including tax breaks relating to dividends, capital gains and estates. In turn, Republicans agreed to keep benefits flowing to long-term unemployed Americans and a cut in the payroll tax; both sides then declared victory. It was not for either group.

What is the state of political play? Either party can block a deal that would take us over the fiscal cliff. It is difficult to understand what the endgame of such a ploy might be. Nevertheless, this whole episode has become a game of “chicken.” Last year, Obama blinked being concerned about his reelection. Who knows what he will do if reelected without any future elections to worry about? If Romney is elected, he promises to craft a compromise. The answer to the first question is that nothing will happen at the end of the year because Congress will extend the date for the fiscal cliff, and our country will continue to kick the can down the road.