The excerpt below from Joseph Heller’s 1961 fictional novel explains that “Catch-22” is a military rule that sets up the necessary pre-requisite to avoid flying combat missions:
"There was only one catch and that was Catch-22, which specified that a concern for one's safety in the face of dangers that were real and immediate was the process of a rational mind. Orr was crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn't, but if he were sane he had to fly them. If he flew them he was crazy and didn't have to; but if he didn't want to he was sane and had to."
The “fiscal cliff” issues that Congress may or may not deal with in the coming weeks are not much different than the situation “Orr” was faced with in Heller’s novel. The following excerpt from the Congressional Budget Office (CBO) report — “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013” — explains the “Catch-22” dilemma facing Congress:
Growing debt would increase the likelihood of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would confront policymakers with extremely difficult choices. Again, the current high level of debt relative to the size of the economy means that further substantial increases in debt would be especially risky in this regard.
Therefore, eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would have substantial economic costs over the longer run. However, as shown earlier in this report, allowing the full measure of fiscal restraint now embodied in current law to take effect next year would have substantial economic costs in the short run.
The CBO report is every bit as circular in its application of logic as Heller’s “Catch-22.” The report seems to be recommending a “kick the can down the road” approach to the pending fiscal cliff as an alternative to simply jumping off the cliff. The implication is that perhaps we should delay the proposed austerity measures currently scheduled and designed to bring deficit spending under control for one more year while at the same time explaining that in so doing we are assuming substantial risk of impeding our ability to borrow at affordable rates.
In other words, we should avoid the fiscal cliff for a little longer. If we follow this course, we avoid the recession resulting from the fiscal restraint initiatives but end up in recession because fiscal irresponsibility. If we go ahead with the planned tax hikes and spending cuts, we go into recession because of these austerity measures. In either case we end up in recession just as Orr ends up flying combat missions.
There are a several major players attempting to coerce Congress into the “don’t jump” camp. Specifically, Federal Reserve Chairman Ben Bernanke — who coined the term fiscal cliff — has moved away from his often repeated position that fiscal matters are not within his purview. Bernanke has chosen to meet with legislators to weigh in on the pending tax hikes and spending cuts. Even Wall Street CEO’s are heading to Capitol Hill to offer their advice on how to deal with the fiscal cliff issues.
Despite arguments to the contrary coming from the “don’t jump” proponents, there is a huge risk associated with delaying the scheduled austerity measures and the CBO is not understating the nature of that risk. On the other hand, if we “do jump,” recession is the likely outcome. To suggest that we should avoid the fiscal cliff seems every bit as irresponsible as suggesting that we should move forward with the tax hikes and spending cuts and just jump off the cliff.
There are many — probably most — who simply refuse to admit that no palatable solution exists to the fiscal cliff issue. The assumption is that we can deal with the debt and deficit when the economy is on stronger footing. That same logic has been applied for four years now as monetary and fiscal stimulus has been injected into the economy at unprecedented levels and to no avail.
GDP growth has proven to be a particularly stubborn problem, having fallen in the first quarter of 2012 and again in the second quarter of 2012. The most recent data showing third quarter results reflects a modest improvement in the rate of GDP growth but on close examination, a substantial portion of GDP for the third quarter was the result of increased government spending in that quarter. The second quarter GDP was a mere 1.25% and the GDP growth rate trajectory has been lower through most of 2012. Likewise, unemployment has resisted all attempts to rejuvenate the economy through stimulus efforts. The U6 unemployment number continues to hover around 15%.
We have reached a point where the fiscal stimulus intended to solve the problem of slow GDP growth and high unemployment can no longer be viewed as a solution. The truth is these stimulus measures — resulting in unsustainable debt and deficits — must now be viewed as part of the problem itself.
The bank crisis of 2008 was the result of a loss in the value of mortgage backed securities held by banks when the “housing bubble” burst. The housing bubble peaked in 2006 and by 2008 the value of mortgage backed securities had dropped in value to the point where a systemic collapse of the banking system in the United States was a possibility.
The chart below shows the impact of the bank crisis on GDP as we slipped into recession in the third quarter of 2008. Technically we remained in recession until the third quarter of 2009 when GDP finally moved higher than the previous quarter.
The recession had an immediate negative impact on unemployment. The U6 unemployment number is the Bureau of Labor Statistics broadest classification of unemployment. The chart below shows the impact of the recession on the U6 unemployment number during the recession period reflected above.
In an effort to prevent a recession resulting from the bank crisis Congress passed the Economic Stimulus Act of 2008. The Act provided for tax rebates to low- and middle-income taxpayers, tax incentives to stimulate business investment, and an increase in the limits imposed on mortgages eligible for purchase by government-sponsored enterprises (GSE). Total stimulus provided by the bill was approximately $150 billion for 2008.
The Economic Stimulus Act of 2008 did not work to avert recession and on Feb. 17, 2009, in response to high unemployment and the recession that had started in 2008, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (ARRA). The ARRA was broad in scope and involved a number of tax incentives and credits. Additionally, the ARRA extended unemployment insurance benefits, provided direct cash payments to qualified recipients, provided funding for work projects, subsidized health care for the unemployed and increased food stamp benefits.
The ARRA, along with monetary stimulus provided by the Federal Reserve with quantitative easing — normally referred to as QE1 — was effective in pushing GDP higher in the third quarter of 2009. There is a general consensus that the ARRA and QE1 were necessary and effective measures that brought an end to the 2008-09 recession.
Although the recessionary slide was halted in the third quarter of 2009, since that time we have not been able to shift private sector sentiment to the degree needed to create real economic growth. Absent the massive injection of government money (borrowed money) back into the economy provided for by ARRA we would have remained in recession. Unfortunately we now find ourselves at a point where we simply can’t borrow any longer to provide the artificial economic prop that has held recession at bay for the last three years.
Much to the consternation of policymakers, the impact of ARRA and QE1 did not achieve the intended purpose. The goal was to provide a stop gap that would fill the void temporarily resulting from a slowdown in private sector spending. The assumption was that private sector spending would accelerate and move back to more normal levels once the fear of recession subsided. The reality is that the private sector continued to take the prudent approach by paying down debt and accumulating savings.
In an effort to buy more time, in December of 2010 Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which extended the Bush tax cuts for an additional two years. As a result of the collective impact of these various stimulus measures, U.S. debt levels had soared by the summer of 2011 to levels that were simply unsustainable going forward. The chart below sets up the dilemma faced by legislators in 2011.
In 2011 U.S. debt had climbed to the point where it was close to equal with total GDP. Deficit spending was out of control and the cost of fiscal stimulus was rapidly becoming a serious problem. The debt ceiling increase was the focal point of a Congressional battle that was bringing the country close to default on scheduled payments for the first time in the country’s history. Finally, a compromise was reached and President Obama signed the Budget Control Act of 2011 into law on Aug. 2, 2011 allowing an increase in the federal debt ceiling subject to provisions that would address the debt and deficit in 2013.
Even though the Budget Control Act of 2011 was enacted in time to avoid default, on Aug. 5, 2011 — just a few days later — Standard & Poor’s downgraded the United States credit rating for the first time in the country’s history. The market’s response to the Congressional battle over the debt ceiling and the subsequent credit downgrade resulted in a sharp sell-off in stocks. On Aug. 1, 2011 the S&P 500 closed at 1286. On Aug. 9, 2011 the S&P put in a low of 1101, a drop of almost 15% in six trading days. The following excerpt explains Standard & Poor’s reason for the credit downgrade:
The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.
More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on Apr. 18, 2011.
Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.
The outlook on the long-term rating is negative. We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.
Standards & Poor’s assessment proved particularly prophetic as Congress did indeed struggle to reach a broader accord. After several attempts to reach agreement, the final version of the Budget Control Act specified an initial debt limit increase in two phases totaling $900 billion. In exchange for the concession on the debt ceiling the bill specified a total of $917 billion in spending cuts over 10 years.
An additional provision of the Budget Control Act allowed the President to request another increase in the debt ceiling of $1.2 to $1.5 trillion subject to a congressional motion of disapproval. In exchange for the additional increase provision, the Budget Control Act called for spending cuts equal to $1.2 trillion, again spread out over 10 years.
The Joint Select Committee on Deficit Reduction, more commonly referred to as the “Super Committee,” was formed to identify specific spending cuts equal to the $1.2 trillion debt ceiling increase provision. The Super Committee was a bi-partisan committee and after months of work trying to agree on specific spending cuts, the committee concluded their work without arriving at an agreement.
The impact of the Super Committee’s failure to arrive at specific cuts was anticipated. If the Super Committee failed to achieve their mandate, then Congress could grant the additional $1.2 trillion debt ceiling increase by simply not acting to disapprove the request, but in so doing across the board spending cuts referred to as “sequestration” cuts would be implemented.
Where we stand today
The CBO report on the “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013” states that tax increases will reduce the 2013 deficit by $399 billion and sequestration spending cuts for 2013 will reduce the deficit for 2013 by another $208 billion.
These tax hikes and spending cuts total $607 billion and represent money that will be pulled out of the economy in 2013. The impact of these actions is a reduction in GDP. The CBO estimates that the first half of 2013 will result in a negative GDP growth of -1.3%. They project GDP growth for the second half of 2013 at +2.3% resulting in an annual growth in GDP of a mere 0.5%. Under the CBO projection and based on their own positive assessment of current trends in the housing market, we still go into recession in the first half of 2013.
The CBO offers another projection based on removing all deficit reduction measures through legislative action in late 2012. Under that scenario, they project GDP growth in 2013 of 4.4%.
The CBO readily admits that these forecasts are tentative at best. There are a number of factors that are beyond the control of Congress that may result in added downside pressure on GDP in 2013. The CBO states:
It bears emphasizing, however, that economic forecasts are very uncertain. Many developments, including the evolution of banking and fiscal problems in Europe and the speed at which the U.S. housing market improves, could cause economic outcomes to differ substantially, in one direction or the other, from those CBO has projected.
The following bullet points represent a very short list of events and circumstances that could negatively impact the CBO forecast:
- Assuming that we continue on the present trajectory, going over the fiscal cliff will leave us far short of a balanced budget. If the current deficit spending level of approximately $1 trillion annually is reduced by the scheduled tax hikes and spending cuts by roughly $600 billion, we will continue to add to the debt at the rate of $400 billion a year.
- It is unlikely that unemployment numbers can remain at current levels as companies scramble to cut costs further in anticipation of shrinking top line sales thereby reducing the tax base further and expanding the deficit.
- Top line sales are almost certain to shrink further from the impact of the contracting economies in Europe and China.
- The $400 billion deficit could double in spite of tax hikes and spending cuts if interest rates rise. A 2% increase in interest rates would result in carry cost of current debt going up by another $320 billion.
If we take the “kick the can” approach and extend tax cuts and defer spending cuts, we will continue to add to the deficit by $1 trillion a year. Even if we assume an optimistic 4% growth in GDP over the next four years and no change in carrying costs of debt, our debt will climb to approximately $20 trillion and GDP will climb to approximately $18.7 trillion — a debt to GDP ratio of 107%.
The scenario above ignores the impact of a recession or an economic slowdown. Consider that even if we were to avoid recession and GDP growth were to somehow grow at a 2% clip over the next four years, GDP would only grow to $17.6 trillion. Add to that scenario a carry cost increase of 2% resulting from an increase in interest rates that seems possible despite the Fed’s efforts to prevent an interest rate spike. Under that scenario we would end up reducing the $600 billion in deficit reduction by $320 billion without adjusting for the compound effect.
In other words debt would increase by an average of $720 billion a year even after the tax hikes and spending cuts leaving us with a debt of $18.8 trillion and a GDP of $17.6 trillion — a debt to GDP ratio that would still end up at 107%. This scenario completely ignores the impact of increased unemployment that would shrink the revenue side of the equation by reducing the tax base. It also ignores the acceleration in spending cuts that will occur in future years under the sequestration arrangement.
The bottom line is that even if we do go over the cliff by ending tax cuts and implementing the sequestration spending cuts, we are not really achieving a great deal. It is entirely possible that even with these austerity measures, we still end up with $1 trillion deficits in future years. There is a legitimate case to be made for the idea that even going over the cliff is not enough.
Is avoiding the fiscal cliff really the right thing to do?
The obvious and natural inclination is to avoid pain at all costs. Heller’s “Catch-22” states: “. . . a concern for one's safety in the face of dangers that were real and immediate was the process of a rational mind.”
There is little question that going over the fiscal cliff presents a “real and immediate” danger to the economic recovery — if you can call it that — in the United States. The conundrum we are faced with in contemplating this real and immediate danger is that by not going over the fiscal cliff we are also exposing ourselves to a real and immediate danger.
The hard reality is that the solution — fiscal stimulus — has morphed into the problem. Fiscal stimulus is designed to stimulate growth. It is not intended, nor can it accomplish, sustained long-term growth of its own accord.
The inconvenient truth is that fiscal stimulus did not stimulate much growth. It merely filled the void left after the recession when consumers and businesses sharply curbed spending and dramatically increased savings. Because the private sector refused to borrow and spend, the federal government stepped in and borrowed and spent for us with a ferocity unparalleled in recent times.
In 2006 the private sector was highly overleveraged. By 2008 the consequence of those excesses were exposed as the housing bubble collapse created a banking crisis that threatened a systemic collapse. As the private sector took cover from the fallout of overleveraging our future, the federal government stepped in and overleveraged our future for us with massive stimulus that has produced unsustainable debt and deficits.
The recession and economic contraction that we experienced in 2008-09 was the result of an overextended economy and part of a normal business cycle that was necessary to bring the economy back in line with reality. The unfortunate consequence of business cycles is that we get caught in the downdraft as the marketplace moves rapidly to seek true price equilibrium.
What has happened in the United States and globally is that governments and central banks have chosen to interrupt the natural cycle with fiscal and monetary policy initiatives. The fiscal and monetary stimulus implemented with the “Economic Stimulus Act of 2008” and QE1 was a reasonable response to the panic that ensued as the banking crisis was exposed. These actions created economic stability and shifted the playing field to a normalized cyclical contraction and away from a state of utter panic.
It provided much needed time to deal with the bank’s capitalization issues. It also allowed companies and individuals to adjust to the contraction period with cost cutting measures. Today we are in a much better position to sustain the cyclical downturn than we were in 2008.
On the other hand the deleveraging process is not complete. There remains a serious problem with “underwater” mortgages despite recent improvement in this area. There are still approximately 10.8 million mortgages that exceed property value. That number represents 22% of the total mortgage market. The total value of negative equity in the mortgage market remains at approximately $689 billion and presents a continuing risk problem to those holding the mortgages. Although approximately 85% of these mortgage are being serviced in a timely manner at the present time, a recession likely would result in an appreciable increase in defaults.
These “underwater” mortgages will continue to keep a lid on the housing recovery and a recession certainly will result in a substantial increase in defaults. Those who talk of a housing market that has bottomed out seem to be ignoring this dynamic. We have a long way to go to complete the deleveraging cycle that began in 2008 and was subsequently interrupted with massive fiscal and monetary stimulus.
Concluding thoughts
Today we find ourselves at the edge of the cliff and no viable solution to the problem exists that will allow us to avoid pain. It is a macro problem and the common practice of looking at specific individual metrics of our economic health for positive signs of recovery is not unlike “failing to see the forest for the trees.”
We don’t want to deal with the inconvenient truth that we are in a real mess, so we take comfort in a monthly jump in retail sales or a weekly drop in new jobless claims. We argue that the housing market has bottomed out based on an increase in building permits or home sales.
We disregard the fact that retail sales data and jobs data are subject to revision in successive months and more often than not — in the last three years — that has occurred. On the housing front, we embrace the positive but fail to consider the massive overhang of “underwater” mortgages that suggest we are a long, long way from completing the deleveraging cycle and really bottoming out in the housing market.
We simply refuse to recognize that the only reason we are, at the present time, not in recession is because of massive public spending that has been financed with borrowed money. Bernanke argues that the recent run up in stock prices has created a “wealth effect” that should make us feel better and therefore, we should be more inclined to open our pocketbooks and start spending.
That argument fully ignores the fact that as we have moved to reduce debt and increase savings on a personal level, the federal government effectively has nullified any positive gain we have achieved by mortgaging our future with government debt. The federal government has done the very thing we have collectively refused to do — borrow and spend.
We tend to have a disconnect when it comes to public debt in that we don’t see it as our debt. However, it is our debt in that we as taxpayers are the only ones who provide the funds to pay off that debt. We have reached a tipping point where the loan is about to be called as scheduled tax hikes kick in next year.
Our debt and deficit problems, our high unemployment problems, our stagnant growth problems and our failed monetary and fiscal policy initiatives collectively represent major headwinds that are not likely to result in a positive outcome in the short term. Our debt and deficits are like a growing cancer that will eventually consume us if we don’t take some harsh measures to put the cancer in remission.
Perhaps we need to back away from the problem and let it continue on its normal course. The market wants to complete the deleveraging process that was started in 2008 and subsequently interrupted with fiscal and monetary policy. The nature of markets are that we undergo periods of expansion followed by periods of contraction.
According to the National Bureau of Economic Research, we have had 12 recessions from 1945 to the present with an average duration of 10 months. On average, a recession occurs about every five years. A recession in 2013 would be consistent with the average and is the likely outcome at this point.
One could argue that the likelihood of a robust recovery is much greater if our political leaders make a concerted effort to attack the debt and deficit issue with a renewed zeal and abandon the failed policies of recent years. As painful as it may be in the short run, the “Catch-22” dilemma we find ourselves in at the present time suggests that a recession is the likely outcome no matter how we deal with the fiscal cliff.
