QE3 launched into a fiscal cliff abyss

One of the main criticisms levelled at Federal Reserve chairman Ben Bernanke is that money printing becomes less effective the more you do it.

With the central bank announcing a third round of quantitative easing, QE3, the charge that Bernanke is risking an inflation outbreak for dwindling economic gains will be repeated all the more.

But Bernanke addressed the inflation question overnight, saying that it remains within the Fed's comfort zone.

We'll have to wait and see whether this remains the case when the US economy starts showing those "significant signs" of recovery the Fed is looking for.

As President Barack Obama and Republican challenger Mitt Romney slug it out in the lead up to the November 6 election, the role of the Fed will become an increasingly heated topic.

But one of Bernanke's greatest frustrations with this criticism from particularly Republicans in Washington is that his mandate to encourage employment is being seriously complicated by political gridlock in the nation's capital.

Bernanke has pleaded with Democrats and Republicans to come up with a solution to the looming ‘fiscal cliff' scenario that's already weighed on business sentiment.

The Fed chairman couldn't have put it more bluntly overnight: "If the fiscal cliff isn't addressed, I don't think our tools are strong enough.”

A new book from legendary ‘Watergate' journalist Bob Woodward chronicles the events of the last three and a half years that have led to the nation's current politically charged economic bind that Bernanke wrestles with.

About half of Woodward's ‘The Price of Politics' is effectively a prologue to this unholy legislation that the Fed chairman is so concerned about.

The fiscal cliff was born out of the Budget Control Act of 2011, which mandated a Joint Select Committee to produce a bipartisan plan to reduce the budget deficit by $US1.2 trillion over the next ten years.

As an incentive for the ‘Supercommittee' to come up with a deal, the Act legislated that by the end of 2012 the Bush era tax cuts would expire, as would the 2010-11 payroll tax cut and emergency unemployment benefits, and $US1.2 trillion in cuts would kick in between defence and non-defence departments.

The incentive wasn't enough. The Supercommittee failed and the US has been staring at this enormous fiscal contraction, which kicks in at the beginning of 2013, ever since.

If the fiscal cliff scenario plays out, the non-partisan Congressional Budget Office estimates that the deficit will be cut in half in 2013. But the economy will pay for that progress with a recession next year as opposed to 1.7 per cent growth in GDP and an unemployment rate of 9.1 per cent as opposed to 8.0 per cent.

Business leaders have made it clear that this nightmare scenario has already made them skittish. Moody's has threatened to downgrade US government debt if something isn't done. All this makes Bernanke's job harder, particularly with interest rates stuck at zero until at least mid-2015.

Given that this campaign is ‘all about the economy,' neither candidate wants the fiscal cliff. So between now and December 31, someone has to do something.

Legislating a delay in the fiscal cliff deadline should be relatively easy. Although as Business Spectator's Alan Kohler wrote on this very issue back in April, "history has shown that anyone who assumes sensible politics in Washington is taking a risk”. (US sleepwalks towards a fiscal cliff, April 7)

The fiscal cliff is a product of the unwillingness of the two parties to agree on cutting into their "sacred cows,” as Woodward explains.

Bernanke knows that QE3 won't boost government revenue enough to solve America's budgetary problems. He needs the two parties to start compromising.

The Democrats are hopelessly protective of Medicare legislation that's out-dated. When asked to raise the age at which point Medicare kicks in to 67 from 65 – a perfectly reasonable argument given the ageing population and people working longer – the Democrats said it could be done gradually… by 2046.

"Talk about kicking the can down the road,” writes Woodward.

But what's most maddening when you read Woodward's book is the consistent inability for Republicans to engage in tax increases on any level, despite mismanaging two wars that were unpaid for (defence spending is a Republican dogma). As former president Bill Clinton said at the Democratic convention last week, one of the things you need to balance a budget is "arithmetic”.

In fact, polls consistently show that a clear majority of rich Americans want to see their taxes increase. It's not just Warren Buffett that thinks the system benefits some over others.

Perhaps the most important argument in Woodward's book is that it's not so much an unwillingness of party leaders to negotiate with each other, it's selling the result to the caucus – Republicans more so than Democrats.

For the Republicans, their opposition to even reasonable tax increases was unquestionably exacerbated by the midterm elections in 2010, when the party was effectively hijacked by the Tea Party.

For the Democrats, their outrage to such illogical debt reduction instincts was somewhat reinforced by the Occupy Wall Street movement.

While the phenomenon was more about political corruption, it coincided with the beginnings of a farcical Republican nomination process that made Obama look like the only reasonable person in the room.

The more fiscally conservative Democrats, known as Blue Dogs, shot themselves in the foot by threatening Obama's stimulus measures in the first few weeks in office. They've since been marginalised, unable to begin even a reasonable discussion about Medicare by players willing to speak about protecting a program that's undoubtedly necessary, but too generous to be sustainable.

As Woodward explains, all this history and more is preventing lawmakers from engaging in a sensible approach to reduce the deficit, all while an election is going on. And the fiscal cliff clock is ticking.

It's that knowledge that feeds the market's worry that the fiscal cliff scenario could play out because the two parties won't move until the November 7 and then dig in too deep to come to an equitable agreement.

All the while, Bernanke has a mandate to encourage employment.

Alexander Liddington-Cox is Business Spectator's North America correspondent.