In a previous post, I suggested that the Federal Reserve Board's decision not to begin tapering its purchases of Treasury securities and mortgage-backed assets may have reflected, in part at least, uncertainties associated with the fiscal cliff that once again looms large on the U.S. political horizon. If that supposition is correct, it could well highlight challenges associated with unwinding the extraordinary policy measure, which was adopted in the wake of the Lehman failure five years ago. It may also have important implications for the global economy and international policy cooperation.
Less than a year ago, attention was transfixed on a political game of chicken between Congress and the Administration. Ostensibly, the game was over U.S. fiscal policy. In reality, however, the stakes were, arguably, much higher — whether the newly re-elected President would be able to pursue his reform agenda in his second term, or be consigned to preside over the longest lame duck administration in history.
The game wasn't resolved as much as deferred in dramatic New Year's eve negotiations, with neither side getting what they sought: the President got some of the tax increases he sought, but not the full package and with the blunt instrument of sequestration tightening fiscal spending. The contentious issue of the debt ceiling was "kicked down the road."
Fast forward nine months and attention is once again focused on the debt ceiling and another fiscal cliff that looms large on the policy horizon. At this point at least, most observers discount the chance of an effective resolution before the Treasury's cash reserves are depleted and its borrowing authority exhausted. Estimates differ and there are undoubtedly contingencies that can be employed to delay the much-feared consequences, but it is clear that there will have to be some action in the coming weeks.
Despite this, markets are ignoring the fiscal cliff — at least for now. The lack of a sense of urgency may reflect the operating assumption that, because a government shut down and the suspension, say, of Social Security payments would probably hurt Republications more than Democrats, some temporary tweak will be found pretty quickly.
The alternative to a showdown in the form of a long-term "fix" looks remote. There is the suggestion, for example, that money be pulled from Obamacare as the quid pro quo for resolving the impasse, but that would simply open the President's key "legacy project" to a death by a thousand cuts; the other possibility is introduction of chain-CPI to entitlements, although this too is unlikely to generate the support necessary.
Nobody gives these options much of a chance. In part, this is because, while the immediate impact of another fiscal showdown would likely increased market volatility, the perceived near-term impacts are fairly innocuous: in fact, assuming that another temporary fix is implemented relatively, the balance of risks is on the upside. This is because the status quo is sequestration and there is no appetite to tighten further; that is, the worst that can happen is the status quo ante. As a result, any "news" will be positive to the economy in that it would entail a lessening of the fiscal drag that is currently holding back growth.
So, the balance of opinion seems to be that the can will, once again, get kicked down the road. That said, this benign perspective may overlook medium-term negative impacts from continuing uncertainty that fosters the option value of waiting effects should there be some negative shock. In this respect, the continuing dysfunction of U.S. fiscal policy — reflecting political gaming — renders the system more vulnerable to possible shocks. And a system that is more fragile is more susceptible to changes in other key policy frameworks, such as shifts in monetary policy.
In the midst of the global crisis, there wasn't much need to coordinate monetary and fiscal policies. The priority then was to prevent another Great Depression; the policy assignment of both instruments was stimulus. In this environment, coordination was superfluous. At some point, however, policy assignments will have to be calibrated more closely to longer-term objectives. As the Fed's decision to not taper suggests, that time has not arrived. Yet, a failure or inability to to do so when the time arrives could endanger the goal of sustainable long-term growth and undermine U.S. credibility in global affairs.