The fiscal cliff and a game of leverage

About thirty-six hours. That’s how much time newly-reelected President Obama’s senior campaign staff had to relax and catch up on sleep after an exhausting year-long campaign. Because in record speed, Washington, D.C. had to quickly turn its attention from the campaign to the next crisis at hand: the fiscal cliff.

This moniker refers to the collection of the $540 billion in tax increases and $195 billion in budget cuts that will automatically take place at the end of the year if no action is taken. It includes the expiration of all the Bush tax cuts, of stimulus provisions like emergency unemployment benefits and a two percentage-point payroll tax holiday; as well as across-the-board spending cuts (otherwise known as sequester) that reduce domestic non-entitlement spending by 8.2% and defense spending by 9.4%.

There is broad consensus in both political parties that something needs to be done to avoid the full brunt of the fiscal cliff, for two reasons. First, both parties have priorities that will suffer: domestic spending and the aforementioned stimulus provisions for Democrats, defense spending and tax cuts for Republicans. And second, the Congressional Budget Office estimates that “going over the cliff” will plunge the country back into a second recession.

The problem, however, is that there is little consensus on how to avoid the cliff. Republicans – who maintain control the House of Representatives – are staunchly opposed to the defense cuts or allowing any of the Bush tax cuts to expire, preferring instead to cut domestic spending and social safety net benefits. The President and Democrats in Congress – who in this election expanded their majority in the Senate – prefer to allow the tax cuts on income over $250,000 (which affects only the top 2% of households) to expire, extend the rest of the tax cuts, and avoid both the defense and domestic spending cuts.

There is some overlap: both parties want to avoid the defense cuts and extend the Bush tax cuts on income under $250,000 ($200,000 for single filers). But that may not matter because neither party is willing to decouple these issues from other priorities. Republicans oppose decoupling the tax issue because they know that cuts for the rich will only be extended if tied to the more popular cuts for the middle class, which are worth about $1,000 to the average middle-class family. For the same reason, Democrats are loath to waive the automatic defense spending cuts without also waiving their domestic counterpart. The linking of the two kinds of tax cuts and spending cuts forces politically powerful constituencies – the middle class and the defense industry – to lobby in favor of tax cuts for the rich and for current domestic spending levels, respectively. Politics indeed creates strange bedfellows.

It should be noted that the Democratic policy preferences are much more consistent with what economists view to be the most effective way to avoid the fiscal cliff. For example, extending the emergency levels of unemployment insurance costs about $10 billion less than extending the high-end Bush tax cuts, but has a job impact over four times as great. Similarly, the across-the-board spending cuts could cause significant job loss relative to their budget cost, while the job impact of allowing the estate and gift tax to rise would be negligible. For this reason, the fiscal cliff may be more aptly deemed the “fiscal obstacle course” because the goal should be to navigate the best path through rather than simply avoid it outright.

So where do we go from here? At this point, the best indicator of the eventual outcome is relative leverage: who is more willing to walk away from a deal and go over the cliff, and more importantly, who believes that the other side is less willing to compromise? For example, at the end of 2010 the Bush tax cuts, along with a host of stimulus provisions, were scheduled to expire. The President had just been “shellacked” in the midterm election, and if all the Bush tax cuts and stimulus expired then he would have entered his 2012 reelection campaign with a significantly weakened economy. Knowing this, Republicans pressed their advantage and, eventually, the President signed a bill extending all the tax cuts – even those for the rich – in exchange for extensions on a modest amount of fiscal stimulus.

This time around, however, may be different. The President has just been reelected, the first Democratic president to be reelected with a majority of the vote since Franklin Delano Roosevelt in 1944, and he can’t run again. In fact, the post-election narrative has suggested that the vote was a ratification not just of the President, but of the very policy that he made the centerpiece of his campaign: higher taxes on the rich. Additionally, the composition of the fiscal cliff is more favorable to Democrats, with most it composed of tax increases rather than spending cuts. Public opinion polls also suggest that if a deal is not made, a majority of voters would blame Republicans, while less than 30% would blame the President.

These factors, however, only translate to leverage if both parties believe they do. It is not enough for Obama to be so committed to tax increases that he will walk away from negotiations if Republicans don’t budge – he must also convince Republicans that he believes his position is strong enough to actually carry out that threat. So the question is not “what will Obama and the Republicans do?” but rather “what do the Republicans believe Obama will do, and what does Obama think the Republicans will do?” A person’s leverage exists solely in the mind if his negotiating partner.

A good example of this is public pressure. Immediately after the election, a coalition of powerful labor groups began running ads pressuring Obama to stand firm on raising taxes on the rich and opposing cuts to safety net benefits. On its face, this restricts Obama’s flexibility, thus weakening his position. But in fact, the reverse is true. This pressure campaign was public for a good reason: so Republicans would know that Obama can’t compromise too much. This, in turn, convinces them that he has less room for concessions (lest he alienate progressive allies that he needs for his second term agenda), making his threats to walk more credible.

But this concept of leverage introduces a paradox that Obama must navigate. On the one hand, Obama’s leverage is based on the credibility of his threat to walk away from negotiations, a threat made more credible by the collective belief that if a deal is not struck, Republicans will be blamed. On the other hand, the public will be less willing to blame Republicans for a breakdown in negotiations if Obama is signaling that he isn’t willing to compromise and starts threatening to walk away. So Obama must simultaneously signal to the American public that he is completely open to a compromise while also signal to Republicans in Congress that he is perfectly willing to walk away from a deal if it does not meet his policy objectives.

The spending cuts and tax increases take effect in about five weeks. In that time, both sides will be playing a complex game of leverage, the outcome of which will determine the level of taxation and funding for our national priorities. It is difficult to overstate the significance of the moment.