Washington's recurring fiscal brinkmanship makes it easy to be pessimistic about the economy. As it is, taxes are certain to rise in 2013 and government spending will fall, with both changes weighing heavily on growth.
But assuming Congress and President Obama do roughly the right thing (and the political stars are aligned so that they should), the fiscal hit to the economy should be manageable. Meanwhile, many of the problems that got us into the current economic mess are being fixed, setting the stage for a much stronger economy by this time next year.The current tax and budget negotiations could play out in many ways, but the most likely scenario has lawmakers agreeing to a comprehensive budget plan in the next few weeks. Such a plan would scale back the massive tax hikes and spending cuts now set to take effect in January, raise the Treasury's statutory debt ceiling, and lay out a credible path to fiscal sustainability.
The scheduled tax hikes and spending cuts, known collectively as the fiscal cliff, will be reduced enough to prevent a recession. Congress can do this in various ways but will most likely extend the Bush-era tax rates for households making less than $500,000 a year, while allowing them to expire for those with higher incomes. The payroll-tax holiday will expire, as will the emergency unemployment insurance program.
As part of the fiscal-cliff agreement, the debt ceiling will be raised enough to avoid becoming an issue for another year. But this won't happen without the consent of House Republicans, who will insist on bigger cuts to Medicare, Social Security, and other spending than the president wants.
While they will burden the economy in 2013, the resulting federal spending cuts and tax increases should put the nation on a sounder long-term fiscal path, ultimately a big economic plus. The cloud of uncertainty about the tax code, and whether we have the political will to address our fiscal problems, will lift from businesses and households.
From the News Desk
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The U.S. financial system has arguably never been sounder. Banks have raised hundreds of billions in new capital, putting important benchmark ratios near all-time highs. Tighter underwriting since the recession has greatly improved credit conditions. The quality of commercial and industrial loans, credit cards, and auto loans is about as good as it gets. The missing ingredient to stronger bank profits is more lending, and banks are steadily opening the credit spigot.
Households' finances are less uniformly good but still are much improved. Higher-income households have shed debt, and most have fixed-rate mortgages whose costs have fallen through refinancing. Lower-income households still struggle to make mortgage and student-loan payments, but across all households, the proportion of after-tax income needed to stay current on outstanding debt will soon be at record lows.
Housing is also seeing a rebirth. After a dizzying six-year-long crash in sales, construction, and prices, the sector turned around this year and will take off in 2013. Owning a home has never been as affordable. Prices fell more than a third in the housing bust and mortgage rates have never been lower. With rents rising strongly almost everywhere across the country, the decision to buy is becoming much easier to make.
The main threat to this optimism comes from politics. A substantive agreement to tackle the nation's fiscal issues is clearly easier said than done. To generate the necessary political will, negotiations may extend into 2013. That is, the nation will need to go over the fiscal cliff, seeing taxes rise and spending cut, at least temporarily. The effect won't be catastrophic, but the economic damage will mount with each passing day, as businesses, investors, and consumers begin to doubt policymakers can come to terms.
Political pressure will grow, providing precisely the incentive lawmakers need to reach an agreement. The real danger is that instead of reaching a comprehensive deal, lawmakers could kick the can down the road, extending current tax and spending policies for a few months or another year. This would signal that policymakers had failed and that fiscal sustainability will require a serious financial crisis.
But while the threat of political failure can't be dismissed, the times appear to favor extraordinary action. This president and Congress do not have to be made of different stuff than their predecessors; they just have to respond in the usual ways to unusual circumstances. If they don't act, tax rates will go up on everyone, which no legislator wants. Neither do they want spending to be cut across the board, with chaotic results to defense and nondefense programs. And both Obama and House Speaker John Boehner are concerned about their legacies, giving them reasons to aim for a historic deal.
What Winston Churchill is reputed to have said about Americans doing the right thing - after they have exhausted all other possibilities - should still apply.
Mark Zandi is chief economist of Moody's Analytics Inc. He can be reached via help@economy.com.
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