A glimmer at the end of the tunnel.
12:00 AM, Dec 11, 2010 • By IRWIN M. STELZER
“Is it an earthquake or simply a shock?” asked Cole Porter in lyrics made famous by Frank Sinatra. That’s what policy analysts are asking about the sudden increase in the interest rates investors in U.S. government bonds are demanding, an increase only partly reversed at week’s end. One would have thought that news that President Obama and congressional Republicans had agreed on a deal on taxes would be soothing music to the ears of nervous investors. One would have been wrong. There is just too much Greek balalaika and Irish bagpipe music filling their ears for them to be soothed by the sweet sound of self-congratulation emanating from the White House and Capitol Hill.
Especially when the president and the Republicans are congratulating themselves on a compromise that increases the budget deficit now to perhaps a record $1.5 trillion in the 2011 fiscal year, estimates Lou Crandall, economist at Wrightson Icap, without cutting it at some later point. Congressional approval is likely but with at least one modification to appease House Democrats who are crying sell-out because the president reneged on his signature campaign pledge to end tax cuts for the rich. They seem likely to get the inheritance tax, which has been zero under the Bush cuts, and is set in the compromise at 35 percent on legacies in excess of $5 million, changed to 45 percent on estates in excess of $3.5 million.
The Bush tax cuts are to remain in place for two years for both Obama’s favored middle class and the higher-income taxpayers that most Republicans and many Democrats believe create jobs. Taxes on capital gains and dividends remain at 15 percent. My Hudson Institute colleague Diana Furchtgott-Roth, writing in RealClearMarkets.com, says the tax deal has saved the economy from “the massive fiscal contraction that would occur in January if taxes were allowed to rise.”
Other aspects of the deal are less pleasing to conservative deficit hawks. The 2 percent one-year reduction in employee payroll taxes for 2011 will add $50 billion to the deficit – its cost of $110 billion is partly offset by the lapsing of Obama’s $60 billion “Making Work Pay Credit” – and the agreement to extend unemployment benefits for 13 months after they expire at year-end adds another $56 billion. Not a lot of money as deficits go, but every billion matters, at least symbolically, when your deficit is crowding double digits and rising. And not a lot of money as stimuli go – three-tenths-of-one-percent of GDP according to some estimates, less say disciples of the great economist Milton Friedman. Recall: Friedman won a Nobel Prize for proving that a temporary tax cut is more likely to increase savings than spending.
As pessimists see things, an opportunity to reduce the deficit has been foregone, while an opportunity to increase it has been grasped. The most dissatisfied believe that the tax increases should have been allowed to go into effect, reducing the deficit by $1 trillion, and relieving the market’s recent upward pressure on interest rates on government debt from what the Financial Times calls, “The ensuing stampede out of Treasuries since the announcement of the tax deal and its new stimulus measures…”.
More spending now, but no deficit-reduction plan being put in place for implementation once the recovery is more robust. True, as the Lindsey Group consultancy is advising its clients, “The American economy has avoided a major political threat to its recovery….But…this bill does not materially change our expectations for subpar 2011 growth in the range of 2 to 2.5 percent.” Or for a continuation of European-style deficits.
Equally true is the fact that the deal seems to have done nothing to calm nervous investors in U.S. IOUs. Already on edge as Greek, Ireland, Portugal, Spain, Italy and, some say, France flirt with default on their sovereign debt, they are watching the printing presses churn out the dollars needed by the Federal Reserve Board to implement QE2, are hearing rumors of the possible launch of QE3, and are learning that compromise in Washington means lower taxes and more spending. No surprise that they are driving down the price of Treasury IOUs, raising interest rates.