While elated that the full 3.5% US fiscal drag was avoided, many observers are understandably dissatisfied with the fiscal compromise that was struck.
Marianne Faithfull’s song “What’s the Hurry” may ironically offer some insight. She asked, “What’s the panic, where’s the static?” That seems to be the key. The fiscal cliff in the US was never about economics, but always about politics. The politicians had tied their own hands and lo and behold figured out a way to untie them.
Politicians, regardless of nationality or political persuasion, like the people they represent, are loath to make difficult decisions unless they are forced. The pressures that usually emanate from large deficits and debt are inflation and higher interest rates. These are not present in the US. Contrary to the predictions of many economists, US interest rates remain low as does inflation.
What is most remarkable then is not that the politicians found some way to untie their hands, but that there is any interest in reducing the deficit in the first place. Recall that prior to the fiscal cliff wrangling there was about 0.75% fiscal consolidation built into the 2013 budget. The Congressional Budget Office estimated the fiscal drag of the full Monty of the cliff would have been 3.5% of GDP. The compromise tax increases appear to worth about a 1% drag, mostly from the end of the payrolls saving tax holiday (thereby restoring funding for Social Security).
It is true that the US Treasury market has sold off sharply in the aftermath of the budget compromise. The 8-9 bp rise in the US 10-year yield looks to be among the largest moves in three months. Yet this is more restrained than in Germany and the UK, for example, where 10-year yields have risen 12-14 bp. This suggests the sell-off in US Treasuries is not a reflection of investors expressing their dismay at the fiscal compromise that lacks spending restraint. Rather the Treasury sell-off is a sigh of relief that a recession in the world’s largest economy has been averted.
Investors as a whole perceive the news as favorable and have bolstered their risk appetites by bidding equities sharply higher, selling off core bonds, and selling the dollar and yen.
The bottom line is that politicians, like all people, respond to incentives and at the moment, the incentives that have in the past prodded fiscal consolidation are not in place. Many pundits try to draw comparisons between the US and Japan. The incentives for fiscal consolidation in the form of higher interest rates and/or higher inflation do not exist there either. Hence Abenomics is the pursuit of aggressive monetary AND fiscal policy.
This suggests that the coming negotiations about spending cuts and the debt ceiling may be fierce and loud, but also will also not produce a dramatic agreement that puts the US on a sustainable fiscal path.