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Obama victory clouded by looming fiscal battle with Congress

Why hello there fiscal cliff. President Barack Obama, shown above, needs to work with a still deeply-divided Congress to avert a potential package of ...
Why, hello there fiscal cliff. President Barack Obama, shown above, needs to work with a still deeply-divided Congress to avert a potential package of tax increases and spending cuts that threatens a recovery that is beginning to pick up momentum.LARRY DOWNING / Reuters

Congratulations, President Barack Obama. Now you have just 49 days to resolve a $600 billion fiscal crisis that could push the economy back into recession.

The slow, steady improvement in the economy that helped Obama defeat Republican nominee Mitt Romney Tuesday is in peril if he can’t quickly forge agreement with a still-divided Congress on a new budget that delays steep tax increases and deep spending cuts.

The so-called “fiscal cliff” – set to take effect Jan.1 – is a doomsday budget package Congress enacted in 2011 to try to force compromise on a series of bitterly divisive policy choices. The budget package is a witch's brew of harsh measures designed to inflict political pain as widely as possible, the better to prompt all sides to reach the compromise that would prevent it from taking effect.

The law slashes Obama’s popular payroll tax cut, cancels extended jobless benefits, imposes deep cuts in Medicare reimbursements to doctors, exposes millions of Americans to the dreaded Alternative Minimum Tax, eliminates tax deductions for state and local sales taxes and child care tax credits (among others), takes a meat ax to defense spending and slashes “discretionary” spending – on everything from education to homeland security – by as much as 10 percent.

Economists and politicians, including Federal Reserve Chairman Ben Bernanke, have warned it would almost certainly wipe out any progress the White House has made in reviving the economy and creating jobs.

Concern about the fiscal cliff was among the factors driving down stock prices sharply in a post-election slump. The Dow Jones industrial average was down nearly 300 points in its biggest one-day slump in nearly a year, pushing the benchmark index below the 13,000 level before it recovered slightly.

Recent reports have shown the economy picking up strength. Growth in U.S. gross domestic product, though still sluggish, picked up to a 2.0 percent annual pace in the third quarter from a 1.3 percent rate in the second. After a pause this spring, the pace of hiring picked up this summer, with employers now adding some 175,000 new jobs a month to payrolls. Consumers are spending more on big-ticket items, like cars and appliances.

A prolonged budget impasse would reverse those gains. The hit to consumer spending from higher taxes, along with the loss of government spending, would knock 3 to 4 percent from GDP, according to the Congressional Budget Office.

Related: Stocks plunge on worries about fiscal cliff, Europe

"If we go back into recession, we will likely pull the global economy with us," said Ameriprise Financial   economist Russell Price. "The longer a (budget) deal takes, the longer the economy suffers. It’s just that simple."

In their election night speeches, both Obama and Romney hinted that members of the newly elected Congress, who have been gridlocked over the issue for months, need to cross party lines to tackle the problem when they resume business next week.

"In the coming weeks and months, I am looking forward to reaching out and working with leaders of both parties, to meet the challenges we can only solve together,” Obama said.  “We are not as divided as our politics suggests. We’re not as cynical as the pundits believe."

“At a time like this, we can't risk partisan bickering and political posturing,” Romney said. “Our leaders have to reach across the aisle to do the people's work.”

There are some broad signs that a congressional compromise is possible before year-end. An influential group of business economists recently indicated support for some new tax increases to balance the budget. Obama and some Senate Democrats have indicated further cuts are needed in large entitlements like Social Security and Medicare, by far the biggest contributors to budget deficits. 

A major flash point remains over the White House's insistence on raising tax rates for the wealthiest Americans – those earning $250,000 or more. The White House recently renewed its threat to veto any budget deal that preserves Bush tax cuts for those high-income earners.

As both sides begin to look for a compromise, that contentious issue remains. Despite campaign spending of some $6 billion, voters re-elected a government with virtually the same political make-up as the one that has been deadlocked for years over tax policy.

House Speaker John Boehner, R-Ohio, told reporters Wednesday that House Republicans “want the president to succeed” and urged broad reform of the tax code. But he renewed his party’s opposition to raising tax rates on the upper end of the income ladder. 

“We’re willing to accept new revenues under the right conditions,” he said. “(But) feeding the growth of government with higher tax rates won’t solve the problem.”

Senate Democratic Leader Harry Reid said he was willing to negotiate with Republicans any time on any issue.

"We have to sit down and go to work on it now, not wait. This was really the message the American people sent," Reid said at a Capitol Hill news conference.

If the House remains dug in over the issue of tax increases, compromise with Senate Democrats and the White House will be difficult to reach – even if it means reversing recent progress in mending the economy.

“With neither party gaining much political capital during the elections, both have little choice but to strive for a compromise that prevents the hikes in taxes and cuts in government spending that are due to start sucking $600 billion, or 4 percent of GDP, out of the economy early next year,” economists Paul Dales and Paul Ashworth at Capital Economics wrote to clients Wednesday.

Last minute deal?
Ashworth and Dales believe that the impasse will likely be broken at the last minute as Democrats agree to extend the tax cuts for high-income earners and Republicans agree to delay spending cuts.

“So although another recession will probably be avoided, postponing the cliff without tackling the underlying long-term fiscal problems will undoubtedly lead to more credit ratings downgrades early next year,” they said.

The U.S. government's failure to get its fiscal house in order after political gridlock set in during the summer of 2011 prompted Standard & Poor's to take the historic step of downgrading the U.S. credit rating from AAA+, its highest, to AAA. Ratings agency Fitch said Wednesday it might follow suit if a pact is not reached quickly.

Some aren't so sure a compromise will be reached in the lame-duck session.

“The House Republicans are not going to vote for an increase in marginal tax rates,” Tony Fratto, a White House spokesman in the George W. Bush administration, told CNBC. “They're not going to do it. This is what they believe in. This is their economic policy. They don't want to see higher tax rates. And they believe it's bad for the economy.”

Given that resistance, some political observers suggest that the White House may let the budget impasse extend through the first of the year, allowing spending cuts and tax increases kick in.

At that point, with rates at much higher, pre-Bush levels, Obama and Senate Democrats could propose large “tax cuts” – for everyone except the wealthiest - that would still leave revenues higher than they are under current law. That strategy would, in effect, amount to a game of chicken, with the economy the biggest potential loser.

The impact could take time to unfold. While clearly dire in the long run, the economic damage from combined tax increases and spending cuts would be felt gradually in the early months of 2013, according to Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities and former economic adviser to the Obama administration.

“The way to think about the fiscal cliff is more of a slope,” he said. “Just going over the fiscal cliff and reversing yourself pretty quickly - the fiscal bungee jump - I don't think it's a good thing, but that's not recessionary.”

Even is a deal if reached, the budget process faces yet another monkey wrench early next year: the looming expiration of the $16.4 trillion debt ceiling. The once-routine process of raising the government’s legal borrowing created the political fracas that produced the fiscal cliff in the first place.