U.S. Debt, Deficit Deal: The Big Questions

The debt-ceiling deal hammered out by the Republicans and the Democrats in the Capitol has averted the risk of a calamitous cuts in federal spending while ensuring failure to service debt will not arise. However, analysts say some big questions remain to be answered.

The following are the key questions raised by IHS Global Insight Chief U.S. Economist Nigel Gault (Full Text):

1. Does the deal mean that the AAA rating is safe?

No. S&P has made clear that its decision on whether to downgrade the U.S. credit rating will depend on the credibility of the deficit-reduction package. S&P had been looking for a large package—on the order of $4 trillion—to make much bigger inroads into the long-term problem. On the face of it, this package falls short of what S&P was looking for—but we cannot be sure how it will react.

2. Does this clear the uncertainty overhanging the economy?

The administration says that this deal "removes the cloud of uncertainty over our economy at a critical time." This is partially true. It removes the danger that gridlock in the political system would produce the calamitous outcome that the U.S. would default on its debt or not pay other spending obligations as they come due. But enormous uncertainty remains over fiscal policy. We do not know whether the bipartisan committee of lawmakers will be able to come to an agreement, what that agreement will contain, or whether its recommendations will be accepted by Congress.

We do not know whether the automatic sequester would really be allowed to kick in if the committee fails. We do not know whether the Bush tax cuts will be extended in whole or in part. We do not know whether the temporary payroll tax cut and emergency unemployment insurance benefits will be extended into 2012. We do not know what shape a permanent deficit fix would take—one that addresses entitlements and revenues and goes well beyond even what the committee is charged with producing. And we can be sure that fiscal policy choices will still play a huge role in the 2012 elections.

3. What is the nightmare scenario?

It is unfortunately rather easy to construct a nightmare scenario involving another collision with deadlines at the end of 2012. Suppose that the bipartisan committee fails. That will mean that automatic sequester will be due to kick in on January 1, 2013. That is exactly the same day that the Bush tax cuts are scheduled to expire. So the result of political gridlock would be a massive fiscal contraction on January 1, 2013. The political landscape at that time would be in a state of flux anyway, because the new Congress would not yet have taken office, and the president might be a lame duck. To make the picture even messier, another (contested) increase in the debt-ceiling would be due at around that time.

4. Will the enforcement mechanism work?

The point of sequester is to create an alternative outcome so unpleasant that Congress will seek to avoid it by coming to an agreement. But a bipartisan agreement would probably have to include both spending cuts and revenue increases—and much of the Republican Party is implacably opposed to revenue increases. There are no revenue increases in the sequester, so one might think that Republicans could simply decide to let the sequester take its course. But they will not want to see the extreme cuts in defense spending that would result (on top of about $350 billion of defense cuts under the initial caps). That prospect is supposed to encourage Republicans to compromise now—but they could decide that they will be better off leaving the sequester ready to trigger, but planning to modify the outcome later, especially if they expect to make gains in Congress (or at the White House) in the November 2012 elections.

The crucial point here is that no Congress can bind the future decisions of another Congress. It is worth noting that the automatic sequester would include Medicare cuts, but in provider payments only. That sounds eerily familiar to the cuts in payments to doctors that are written into law but which Congress routinely overrides every year. Bottom line: we cannot be sure that the threat of sequester will achieve its purpose.

5. Will the cuts in spending harm short-term growth?

The immediately enacted cuts will build up only gradually. The CBO has estimated that the discretionary spending cuts will reduce actual outlays by $25 billion in fiscal 2012 and $46 billion in fiscal 2013, relative to the CBO's March baseline (in its baseline, the CBO assumes that spending grows with the rate of inflation). In a $15 trillion economy, these cuts amount to about 0.3% of GDP by 2013. Allowing for multiplier effects, the cuts might reduce growth by around 0.2 percentage point in both 2012 and 2013 relative to the CBO's baseline. These are not catastrophic effects, but the question is whether we should be tightening fiscal policy at all in such a weak economy. If sequester hits in 2013, the contractionary impact would be harsher.

6. What about stimulus?

There is no mention in the debt deal over what will happen to the 2% payroll tax cut and to emergency unemployment insurance benefits in 2012. At present, both of these stimulus efforts are scheduled to expire in 2012. Whether they are extended or not will have far more impact on the fiscal policy stance in 2012 than the spending cuts announced in the package, since combined they are worth more than $150 billion.

7. How will the pending expiry of the Bush tax cuts affect the work of the bipartisan committee?

Under current law, the Bush tax cuts are set to expire at the end of 2012. The CBO's baseline is based on current law, so it therefore includes an assumption that the Bush tax cuts will expire on schedule. Since the committee's work will use the CBO baseline as a starting point, it too will be starting from an assumption that the Bush tax cuts expire. So if the committee tinkers with the Bush tax cuts, by retaining some but not all of them, it will be creating a revenue loss relative to the baseline that it would have to make up somewhere else. This constraint has led House Speaker Boehner to declare that it will be effectively "impossible" for the committee to raise taxes.

That is not quite true, since the committee could recommend other income tax changes that are not linked to the Bush tax cuts (e.g., reducing the value of tax deductions) or it could recommend other non-income tax changes (e.g., gasoline taxes, or a VAT). But it does make it unlikely that the committee would decide to tinker with the Bush tax cuts.