The economy is already falling off the fiscal cliff. If agreement fails, after year-end, citizens will experience reduced take-home pay and higher tax bills. There will be unforeseen job losses at public and private entities that depend on federal funding and contracts.
Monetary policy has been hard at work. Households have stepped up sharply their purchases of homes, autos, and other durable goods. Improvement in business has been partly offset by reductions in military and state and local government outlays. Business capital investment is shrinking and the consumer index fell nearly ten percent, from November to December.
Growth in credit and debt is vital to a modern economic system. The current prospect is that government borrowing will be reduced more rapidly in coming years.
Natural disasters, such as Sandy effect the fiscal debate and tend to strengthen business in the short run, because they impel large public and private expenditures for repairing the damage. That sort of budget compromise, if it were of a longer-term nature, would be the best possible outcome of the current fiscal cliff “negotiations.” Unfortunately, no such agreement is likely, since President Obama is himself an austerity advocate; he just wants to “distribute” the austerity in different ways than the Republican opposition.
Conceivably, no compromise will be reached at all, mainly because of deadlock on the issue of extending the debt ceiling. Unless the ceiling is abolished, or raised in unassailable fashion for a number of years, any agreement will be worthless.
Absent a benign fiscal agreement, high quality bond yields may well decline even further. Meanwhile, the cost-of-living index will be sustained by the increasing prices of utilities, transit, education, and medical care, as governmental supports are reduced.
The threat of the euro’s collapse has abated for the moment, but putting the single currency right will involve years of pain. The pressure for reform and budget cuts is fiercest in Greece, Spain, and Portugal, and Italy, which all saw mass strikes and clashes with police. But ahead looms a bigger problem that could dwarf any of these: France, always at the heart of the euro, as of the European Union. President François Mitterrand argued for the single currency because he hoped to bolster French influence in an EU that would otherwise fall under the sway of a unified Germany. France has gained from the euro: it is borrowing at record low rates and has avoided the troubles of the Mediterranean. Yet even before May, when François Hollande became the country’s first Socialist president since Mitterrand, France had ceded leadership in the euro crisis to Germany. And now its economy looks increasingly vulnerable as well.
France has its strengths, but its weaknesses have been laid bare by the euro crisis. For years it has been losing competitiveness to Germany and the trend has accelerated as the Germans have cut costs and pushed through big reforms. Even as other EU countries have curbed the reach of the state, it has grown in France to consume almost 57% of GDP, the highest share in the euro zone. Because of the failure to balance a single budget since 1981, public debt has risen from 22% of GDP then to over 90% now.
The Eurozone periphery shows little sign of recovery: GDP continues to shrink, owing to ongoing fiscal austerity, the euro’s excessive strength, a severe credit crunch underpinned by banks’ shortage of capital, and depressed business and consumer confidence. Moreover, recession on the periphery is now spreading to the Eurozone core, with French output contracting and even Germany stalling as growth in its two main export markets is either falling (the rest of the Eurozone) or slowing (China and elsewhere in Asia). There has been some progress in the Eurozone periphery in the last few years: fiscal deficits have been reduced, and some countries are now running primary budget surpluses (the fiscal balance excluding interest payments). Likewise, competitiveness losses have been partly reversed as wages have lagged productivity growth, thus reducing unit labor costs, and some structural reforms are ongoing.