Fiscal cliff freefall

In an exclusive interview, the architect of the original Bush tax cuts tells Business Spectator why fiscal cliff negotiations have done little to solve America’s underlying economic problem.

The architect of the original George W Bush tax cuts (the ones due to expire on January 1), also an economic adviser to Mitt Romney, says that unless Congress can put aside its differences this coming year we will experience four more years of ‘fiscal-cliff’ style gyrations.

Glenn Hubbard, chairman of the Council of Economic Advisers to Bush Jr and a likely candidate for chairman of the Federal Reserve or Treasury Secretary had Romney won, told Business Spectator that 2013 is the only year where parties are not distracted by the US congressional and presidential election cycles, and failure to deal with the United States’ ballooning debt will result in market scepticism until 2017.

"If you look at the American political calendar”, he says, "virtually everything has to happen next year if it is to happen for four years. It's really an imperative that the president and Congress act.”

Hubbard warns that failure to act could easily tip the US back into recession. "It will generate enormous uncertainty”, he says. "Only people… in Washington… believe in this bungee jumping theory of the impact of falling off the fiscal cliff [with] the notion that we will bounce back.”

"As it is so many business people are sitting on decisions, simply waiting for this to happen.

"Our underlying growth is only 1.5 to 2 per cent. The longer you lengthen that uncertainty… it doesn't take much to turn that into a recession.”

The irony is that the event that may push the US, and possibly the world, back into a recession – this "fiscal cliff” – is purely a construct. It is a manufactured scare-tactic designed to strong-arm both parties into making the ideologically painful choice to either cut entitlement spending (Democrats) or raise taxes (Republicans), or both.

As the Office of Management and Budget Acting Director, Jeffrey Zients, wrote to Congress, "The spectre of harmful across-the-board cuts… was intended to drive both sides to compromise. The sequestration itself was never intended to be implemented… [N]o amount of planning can mitigate the effect of these cuts. Sequestration is a blunt and indiscriminate instrument. It is not the responsible way for our nation to achieve deficit reduction.”

Treasury Secretary Tim Geithner has already warned that the US will hit its debt ceiling in January. The last time that happened – in August 2011 – Standard & Poor's cut the US debt rating, citing the failure of politicians, and markets fell 16 per cent.

That’s why the US volatility index, or VIX, jumped 17 per cent last week. Traders are nervous that, yet again, House and Senate leaders won’t be able to come to that compromise.

Glenn Hubbard, a staunch Republican, encapsulates how far the divide is between the two parties. "The president makes it seem like you can have any government you want and just tax the rich but that's just false”, he says. "The President's position seems to be of someone who wants to go off the cliff. His behaviour would indicate going off a cliff is fine.”

Hubbard believes that the answer to the US fiscal woes is a long-term reduction in entitlement spending. He calls for a limit on the payments made to Medicare and Medicaid, and cuts to social security. As he sees it, too many affluent Americans are relying on social welfare, something which will continue to drive up costs unless it addressed.

Democrats continue to assert that social security should be protected, arguing that higher taxes on wealthy Americans are needed.

But, unsurprisingly for the economist who engineered the original tax cuts, Hubbard believes that increasing taxes on the wealthy will do little to address the problem.

"You can raise taxes on the affluent all you want but it's a band aid – it's tiny. If you took higher rates on earned income, dividend and capital gains, states, deduction limits etc it's 1 per cent of GDP.”

The way this debate is unfolding, there is little likelihood of a deal. Democrats refuse to touch social security, Republicans are only conceding tax increases for those earning over $US400,000 a year. If they fail to reach a deal, the fiscal cliff deal would see $536 billion in tax increases and $110 billion in spending cuts come into force on January 1.

The problem won’t end there. Instead, we’ll see much hand wringing and horse trading as parties attempt to unwind those cuts, with policy uncertainty the only certainty.

Given that US equities are "priced to perfection” as Glenn Hubbard describes it, that will only mean more turbulent times ahead for markets and the economy.