Macroadvisers: January 2013

Enactment of the American Tax Relief Act of 2012 (ATRA) eliminated the near-term uncertainty surrounding tax policy, shifting attention to three other downside fiscal risks to our forecast.

A brief encounter with the debt ceiling this winter might not be calamitous, but a prolonged one would cause the deepest recession since the Great Depression.
Just the possibility of hitting the debt ceiling could create enough uncertainty to reduce GDP by roughly ½ percentage point this year, even if the ceiling is raised before it is reached.
Imposition of the full sequester on March 1 would reduce GDP growth by roughly ¾ percentage point in 2013 relative to our forecast.
A brief shutdown in April of the federal government would cut GDP growth in the second quarter by about ¼ percentage point for each week it lasted. However, the longer the shutdown, the worse and more chaotic the outcome.

Three Looming Deadlines

ATRA may have clarified near-term tax policy but three looming fiscal deadlines pose downside risks to our forecast. First, unless the debt ceiling is raised, the Treasury will be unable to pay all its bills by late February or early March. Second, ATRA delayed until March 1 the sequester originally enacted under the Budget Control Act of 2011 (BCA). Our forecast presumes the full sequester is avoided, replaced instead with smaller spending cuts, but we could be wrong. Finally, the federal government is operating under a continuing resolution that expires March 27. Unless new spending authority is legislated by then, non-essential government functions could be shut down at the end of the first quarter.

Debt Ceiling

The United States hit its debt ceiling on December 31, 2012. The Treasury will use temporary financial maneuvers to continue paying its bills through late February or early March.[1] Thereafter, unless the debt ceiling is raised — or some other strategy is adopted to circumvent it[2] — the federal government will be unable to meet all of its current financial commitments in a full or timely manner. In that event, the Treasury likely would manage its cash flow to meet interest payments on the national debt, thereby avoiding a sovereign default.[3] However, the government could fall into default on contracts with private vendors, and be perceived as having broken long-standing social compacts with the beneficiaries of entitlement programs.

A De Facto Balanced Budget Amendment

In terms of expenditure flows, hitting the debt ceiling is like enforcing a Balanced Budget Amendment (BBA) daily and from the spending side of the ledger only. While the Treasury could meet all its interest obligations, the budget would have to be brought into balance immediately and kept there by varying other outlays. The result would be a reduction in the level of spending that, on average, would be not only very large, but also, given the seasonal “lumpiness” of tax receipts, very volatile.

Some have suggested that if the Treasury avoids sovereign default, damage from enforcing the debt ceiling for even a lengthy period could be limited by prioritizing and juggling other payments. To appreciate the folly of this view, suppose the debt ceiling became binding in March and remained so through 2014. For the rest of 2013, the “static” reduction in spending would average roughly $825 billion at an annual rate, or roughly 5% of GDP.[4] This is a huge fiscal contraction to occur abruptly. For example, we recently estimated that the contraction associated with the “fiscal cliff,” which was a smaller 4¼% of GDP, would have thrown the economy into recession. Furthermore, most of the contraction associated with the fiscal cliff was from tax increases, which have smaller multipliers than the spending cuts necessary to enforce the debt limit. And, were such cuts implemented for a sustained period, as the economy fell into recession and tax revenues declined, additional cuts would be required to keep the budget balanced and avoid additional debt issuance. This, in turn, would further steepen the economic downturn.[5]

Just how dire might be the outcome? To see, we ran a simulation in which the debt ceiling becomes binding in March and remains in force through the end of 2014. The Treasury is assumed to meet all interest payments on the national debt but cut other spending proportionately to bring the budget into continuous balance through the fourth quarter.

For example, our baseline forecast shows a unified budget deficit in the first quarter of $1.095 trillion at an annual rate (not seasonally adjusted). However, in three of the last four years, roughly 40% of first-quarter deficits have accumulated during March. If that same pattern were to repeat this year, it would take a static spending cut of $1.314 trillion against our baseline to balance the budget in March, thereby reducing first-quarter spending by $438 billion (= 1/3 of $1.314 trillion), all at annual rates. For the second quarter, our forecast shows a relatively small deficit of $533 billion because April sees strong revenues. This requires a sequential cut in spending from the first to the second quarter of $95 billion (= $533 billion less $438 billion, but implying a huge $800 billion rebound in spending from the March level). In the third quarter, our baseline deficit rises to $745 billion, requiring a sequential cut in spending of $213 billion (= $745 billion less $532 billion), and the respective numbers for the fourth quarter are $809 billion and $64 billion (= $809 billion less $745 billion). In the simulation, even larger “dynamic” cuts in spending are required to offset the loss in revenue associated with the weakening economy.

This pattern of expenditure cuts is repeated in 2014, but that can’t be the whole story. Appetite for risk would also decline in this scenario, although it is hard to know by how much, and for how long. However, some allowance must be made for the uncertainty that would accompany 30% absolute (that is, not relative to a rising baseline) across-the-board cuts in non-interest outlays against the backdrop of abrogated legal contracts and social compacts. In our model, the VIX is used as a general marker for risk that influences the prices of risky assets which, in turn, affect aggregate demand. For this experiment, we introduced a spike in the VIX two-thirds the size, but of the same duration, as the spike that occurred during the financial crisis in 2008 and 2009.

The results of a model simulation involving both the required spending cuts and the spike in the VIX are shown in Charts 1 and 2.

The unified budget deficit falls into balance after the first quarter of this year. GDP growth, shown here as the percent change from four quarters earlier, turns sharply negative, hitting -8% in the fourth quarter of this year before then rising to 0 by the end of 2014. This would be the worst recession since World War II by a wide margin, sending the unemployment rate soaring above 14% by the middle of next year. We don’t want to make too much of this simulation, since even in today’s rancorous political climate such a disastrous scenario seems improbable. The results are more relevant for a discussion about the impact of a strict balanced budget amendment. Nevertheless, they do emphasize that if the Treasury is constrained by the debt ceiling for any meaningful period of time, economic performance could worsen quickly and quite dramatically.

Uncertainty is Bad Enough

Perhaps the most likely scenario is that during the exercise of partisan brinkmanship, the US approaches or even briefly hits the debt ceiling and that, given its daily cash flows, the Treasury has insufficient balances to meet a contractual obligation or pay promised benefits on time, thereby “defaulting” on those commitments before a resolution to the political impasse is reached. This scenario is not as dire as a sovereign default, but it is bad enough since it would heighten uncertainty about federal financial flows, call into question the meaning of “full faith and credit” of the U.S. government, undermine the credibility of our political institutions, reduce our standing with the rest of the world, and encourage rating agencies to downgrade U.S. debt further.

The events of the summer of 2011 suggest that the political brinkmanship preceding the eventual resolution of the debt-ceiling crisis in August created uncertainty that slowed GDP growth in the third quarter of that year. We could be in for a repeat of those events during the first quarter of 2013. How much might such uncertainty slow growth in 2013?

To answer this question we began by examining the Index of Policy Uncertainty (IPU) developed by Baker, Bloom, and Davis.[6] The IPU reflects mentions by the media of policy uncertainty, forecasters’ disagreement about federal purchases of goods and services, forecasters’ disagreement about inflation, and scheduled expirations of taxes. The index spiked in the summer of 2011 during the dispute over the debt ceiling. (See Chart 3). Intuitively, such uncertainty could slow economic growth by encouraging households and businesses to delay decisions and by reducing the price of risk assets.

The IPU does not appear in our macro model, but Baker et. al. emphasize that their index is correlated with the VIX, which, as already noted, functions in our model as a general marker for uncertainty. Hence, we developed a simple model relating the VIX to the IPU, and, using that equation, we estimated that the spike in the IPU during the last debt-ceiling crisis raised the VIX by about 4½ points during the three months centered on August of 2011. [7],[8] Our published forecast does not show a VIX shock in the first quarter related to the uncertainty over the debt ceiling. However, by introducing an uncertainty shock similar to the one associated with the debt-ceiling debacle of 2011, we can simulate the potential impact on GDP growth of a similar stand-off in 2013.

We ran such a simulation assuming that a 3-month shock is centered on February, when the debt ceiling could first become binding. The results of this experiment are shown in Chart 4. They suggest that a temporary rise in uncertainty surrounding the approach to the debt ceiling could trim 0.4 percentage point from GDP growth over the course of 2013.

Sequester

ATRA delayed the BCA sequester by two months (to March 1) and paid for the delay by reducing in 2013 and 2014 the caps on discretionary spending implemented under the Budget Control Act of 2011. While our forecast shows a path for discretionary spending that is lower than implied by these modified BCA spending caps, it is above the path implied by the now-delayed sequester. (See Chart 5.)

Suppose our assumption that the full sequester is avoided proves wrong, and on March 1 discretionary spending drops from our baseline to the lower path consistent with ATRA. How would that affect our projections for growth this year and next?

We simulated this as a reduction in the level of federal consumption and gross investment (relative to our forecast) that builds from $4 billion in the first quarter of this year to $65 billion by the fourth quarter, and then is maintained through 2014. In addition, the sequester would reduce the level of spending on healthcare entitlements by an amount that grows to roughly $10 billion per year. The results of this simulation for GDP growth are shown in Chart 6, and the effects are sizable.

GDP growth is reduced by 0.7 percentage point over the four quarters of 2013 (from 2.6 to 1.9) and by nearly a full percentage point over the second half of the year as the cuts build cumulatively. The static drag ends in 2014, but, given lags and multiplier effects, GDP growth in 2014 is only marginally higher than in our forecast.

Shutdown

The continuing resolution under which the federal government is now operating expires on March 27. Unless that authority is extended, non-essential functions of government will shut down, as was threatened in 2011 and as occurred twice during the budget wars between President Clinton and then Speaker of the House Newt Gingrich. A federal shutdown seems a real possibility. High-ranking Republicans are regularly quoted threatening such action.

In early 2011 we published a detailed analysis of how a brief shutdown of the federal government would be treated in the National Income and Product Accounts and hence how it would affect GDP growth.[9] It was a quick exercise to update that analysis.[10] If, starting on April 1, a shutdown began affecting 36% of federal civilian workers, the static effect would be to reduce GDP growth in the second quarter by roughly ¼ percentage point for each week the shutdown lasted, and raise it a similar amount in the third quarter.[11] The effect would arise mostly from the furloughing of non-essential federal workers whose production is valued at labor costs in the National Income and Product Accounts. If the shutdown was (expected to be) brief, the knock-on effects would be small. However, the longer the shutdown lasts, the broader its impact becomes and the more one must factor into the analysis multiplier effects as well as the escalation of uncertainty that would accompany a sustained disruption in government services and payments to federal contractors.[12] Of course, if the shutdown persisted long enough it could become quite severe because, unlike the de-facto BBA — which merely reduced spending to the level of taxes — a prolonged shutdown of the federal government could eventually zero out many categories of expenditures.

Summary Remarks

Fiscal policy is a mess. Both Republicans and Democrats involved in budget negotiations maintain positions hardened by ideological differences over the role of government in society, differing views about the trade-off between the short-run costs of a fiscal contraction and the long-run benefits, and political positioning.

In our view, a sharp fiscal contraction — or even the threat of one — imposed when the economy is still struggling to recover from the great recession and when the Federal Open Market Committee has limited options to offset any new fiscal drag, is bad policy. It is made worse if implemented outside the normal budget process in a series of stop-gap actions that, by using calendar considerations as points of leverage, create attendant uncertainty.

The debt ceiling, the sequester, and the expiring budget resolution comprise a three-pack of uncertainties that in the near term is bad for the economy. Because we assume a benign and sensible resolution to the current fiscal dispute in relatively short order, at least the fiscal risks around our forecast appear asymmetric to the downside.

[1] These maneuvers, which include delaying payments to federal pension funds, create about $200 billion of headroom for the Treasury to operate early in the year.

[2] Three such strategies have been discussed in the media. In the first, the President, citing Section 4 of the 14^th Amendment to the Constitution which reads “the validity of the Public Debt of the United States, authorized by law…shall not be questioned,” simply ignores the debt limit and instructs the Treasury to continue issuing debt. In the second, the Treasury uses an obscure legal authority to mint a platinum coin with a $1 trillion denomination, deposits the coin in the Treasury’s account at the Fed, and draws on the account to keep paying its bills. In the third, the Treasury issues IOUs — sometimes referred to as scrips — that, while technically not debt, serve the same purpose. A secondary market for the scrips could even be encouraged in the private sector, allowing holders to sell their IOUs at a discount rather than waiting for the Treasury to honor the pledge later when a deal on the debt ceiling is finalized. These schemes are certainly inventive, but an attempt to implement any one of them would almost certainly trigger legal challenges if not a constitutional crisis. We see all of them as unlikely and, indeed, the Obama Administration already has ruled out the first two.

[3] There has been considerable speculation about how the Treasury might, in the event of a cash shortfall, prioritize the roughly 80 million payments it makes every month. Interest payments on the debt are made over the Fed wire system and could be handled separately with relative ease. Regarding other payments: in 2011 the Treasury leaned towards a strategy of simply delaying payments and then, upon receiving revenues, making what payments possible in the order due.

[4] Our current forecast shows NIPA federal net borrowing at $843 billion in calendar year 2013, relative to nominal GDP of $16,299 billion.

[5] “Balanced Budget Amendment: A Poor Idea,” Macroeconomic Advisers’ Macro Musing (Volume 4, Number 15; July 29, 2011).

[6] Scott R. Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty;” www.policyuncertainty.com.

[7] Not all of the spike in either the IPU or the VIX during the summer of 2011 can or should be attributed to the policy uncertainty surrounding the dispute over the debt ceiling. A significant increase in the perceived risks surrounding the Eurozone crisis also occurred at that time.

[8] The equation regressed the change in the monthly average VIX on the current and lagged change in the Index of Policy Uncertainty (t-statistics in parentheses):

[9] “From Showdown to Shutdown? The GDP Effects of a (Brief) Federal Government Shutdown,” Macroeconomic Advisers’ Macro Focus (Volume 6, Number 2; February 25, 2011)

[10] Our updated “Shutdown Calculator” is available upon request.

[11] The first of the two shutdowns during the Clinton-Gingrich standoffs lasted five days (November 14 to November 19, 1995) and affected roughly 747,000 civilian workers, or one-third the total. The second shutdown lasted twenty one days (December 16, 1995 to January 6, 1996) but affected only 284,00 civilian workers (or 14% percent of the total) because by then a defense bill had been enacted covering the civilian defense employees. The latter circumstance could be relevant today as both the House and the Senate have passed defense appropriation bills for 2013. Hence, it seems likely the Department of Defense will be funded by March 27, limiting the effect of the shutdown to non-defense functions.

[12] Because they originate from trust funds, Social Security and Medicare benefits likely would not be threatened.

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In the early hours of January 1, the House passed The American Taxpayer Relief Act of 2012 (ATRA), partly clarifying the view over the fiscal cliff.

The particulars of ATRA are close to our previous assumptions, and so suggest only the slightest revisions to our forecasts for GDP growth, unemployment, and inflation.

Our forecast published December 28 showed GDP growing 2.6% over the four quarters of 2013 and 3.2% over 2014, with the unemployment rate ending 2014 at 7.2%.
After incorporation of ATRA, our projections for GDP growth are barely changed: 2.7% over 2013 and 3.2% over 2014, with the unemployment rate ending 2014 at 7.1%.
These trivial differences have little implication for our monetary policy call.

While our fiscal assumptions remain similar to those incorporated in our forecast published on December 28, there are three areas of difference worth noting that arise from ATRA.

Personal Taxes
Our forecast published December 28 assumed the tax increase on upper-income taxpayers would raise $709 billion in revenues over 10 years. We estimate the increase under ATRA is a smaller $620 billion over 10 years. This difference arose mainly because the President relented on his pledge to raise tax rates on taxpayers with income over $200,000 (single filers) / $250,000 (joint filers), instead accepting the higher thresholds of $400,000 (single filers) / $450,000 (joint filers). While this smaller tax hike does imply some additional stimulus in 2013 relative to our published forecast, the effect is small. The tax increase assumed for 2013 in our published forecast is $55 billion; under ATRA, it is a smaller $48 billion.

Business Taxes
Our forecast published December 28 assumed a variety of business tax extenders, including 50% bonus expensing for business purchases of equipment and software, would expire on December 31. Instead, ATRA extends them for another year. This will re-arrange our projected path of investment spending, raising it slightly in 2013 and lowering it back down later on by an equivalent amount.

The Sequester
Our forecast published December 28 assumed the sequester would be avoided and be replaced with a more gradual pace of spending restraint. ATRA takes the first step in this direction by delaying the sequester, albeit briefly, and then paying for the delay over a decade. Two months is not nearly enough time to settle on fundamental tax and entitlement reform, so we still expect another delay or perhaps the kinds of spending cuts (consistent with our forecast) that were being discussed in the run-up to January 1. For now, then, we are making no changes to our spending assumptions.

Including the details of the American Tax Relief Act of 2012, here are our revised fiscal assumptions.

The new Affordable Care Act taxes are effective as scheduled on January 1, 2013.
Payroll tax holiday expired as scheduled on December 31, 2012.
Under ATRA, emergency unemployment benefits are extended through December 31, 2013.
ATRA includes a personal tax increase effective January 1, 2013:

a 39.6% rate on ordinary income for taxpayers with incomes >$400,000 (single filers) / $450,000 (joint filers), up from 35%;
a 20% rate in capital gains and dividend for taxpayers with incomes >$400,000 (single filers) / $450,000 (joint filers), up from 15%;
re-instates PEP and Pease limitations for taxpayers with incomes > $250,000 (single filers) / $300,000 (joint filers);
increases estate tax rate from 35% to 40%; and
extends refundable tax credits for five years.

ATRA makes permanent the rest of the “Bush tax cuts.”
ATRA makes permanent the fix to the Alternative Minimum Tax.
ATRA extends the R&D credit and bonus depreciation through 2013.
ATRA extends the farm bill for 1 year, thus avoiding a huge increase in dairy prices; we continue to assume a way will be found to avoid that price increase in 2014.
ATRA extends the “doc fix” for 1 year and pays for it over 10 years with cuts in medical spending; we continue to assume the “doc fix” will be extended beyond 2013.
ATRA delays spending sequester for two months, and pays for it over 10 years by:

reducing Budget Control Act of 2011 discretionary caps for 2013-2014 and
allowing conversions to Roth Retirement Plans.

However, we continue to assume that the sequester ultimately will be replaced with a more gradual squeeze on spending.

Fiscal Risks
The near-term outlook for taxes has been clarified. The principal fiscal uncertainties surrounding our short-run forecast are now on the spending side. These are intertwined with three important dates.

The full sequester is now scheduled to take effect March 1.
Technically, the U.S. hit the debt ceiling in late December; the Treasury temporarily can employ unusual means to avoid default, but only until late February or early March.
The continuing resolution under which the federal government is now operating expires at the end of March. Without a new resolution, the federal government will shut down in April.

We intend to monitor developments closely through the quarter and make changes to our forecast as warranted.

The Longer View: So Much More Work to Be Done
While it may be a relief to have avoided plunging off the fiscal cliff, it is disconcerting how little progress has been achieved towards longer-term deficit reduction since the passage of the Budget Control Act of 2011. Estimates are that, relative to 2012 policy, ATRA 2012 will reduce deficits by only about $650 billion through 2022, with essentially none of that on the spending side of the ledger. There is a lot more work to be done!

This is from a commentary that was published on January 2, 2013.

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