Clock Ticks on U.S.'s Fiscal Time Bomb

David Wessel writes in The Wall Street Journal:

Pundits and pollsters speculate hourly on the outcome of the next Republican presidential primary. Business executives and investors increasingly focus on whether Congress and the president will defuse the fiscal time bomb they have built—or whether they will be so paralyzed that the bomb will go off at year-end.

Without congressional action before Dec. 31, here's what happens:

A payroll-tax holiday ends, which means a tax increase for workers of as much as 2% of wages.

Income-tax rates revert to pre-George W. Bush levels, rising not only for the rich but for nearly all taxpayers.

Across-the-board cuts in domestic and, particularly, defense spending are triggered.

The federal debt bumps up against the legal ceiling, at some point yet to be determined, reviving confidence-rattling headlines about a potential U.S. default.

That's just a partial list. Federal Reserve Chairman Ben Bernanke calls this "a massive fiscal cliff." Abrupt tax increases and spending cuts, which together would equal roughly 3.5% of the nation's gross domestic product, would devastate an economy not fully recovered from a deep recession.

No one in Washington wants that. The rule of thumb is that if no one in Congress or the White House wants something, politicians will find a way to prevent it. But these days, well, you never know. There are three possible outcomes:

Scenario One: The grand compromise.

One reason this is politically tough is that there is no pain-free deficit cure. With a lid on annually appropriated spending, most Republicans' answer to long-term deficits is to cut future benefits from what they would otherwise be. The Democrats' answer is to cut benefits and raise taxes. Resolving that disagreement is key.

If Mitt Romney or another Republican wins the White House, congressional Republicans won't flinch on taxes in a lame-duck session. And if Barack Obama is re-elected and Republicans lose some seats in the House? Would an emboldened Mr. Obama and chastened Republicans cut a deal? Possible, but unlikely.

Just in case, though, the deficit-reduction lobby and sympathetic members of Congress are drafting plans. To make a point, a small bipartisan bunch is putting one tax-hike-and-spending-cut plan to a vote in the House this week.

Odds: 25%.

Scenario Two: A standoff.

If neither side wins big in November, Congress may be unable to pass legislation that defuses the time bomb—unless a measure hitches a ride to must-pass legislation to, say, lift the federal debt ceiling or avert a government shutdown.

If lawmakers can't agree, then taxes will go up and spending will be cut across the board. Then Congress and the president (the re-elected one or a new one) would negotiate from a new starting point, softening the blow retroactively. This has been done before, but it's unsettling and messy, and adds to already more-than-ample uncertainty.

Odds: 25%.

Scenario Three: Kick the can down the road.

Faced with unappealing alternatives, Congress is always tempted to look for a way out. The obvious one: Suspend the tax increases and across-the-board spending cuts for a time, declaring they would endanger the economy and national security. Promise—really, truly—to fix the deficit later. No one will advocate for this in advance, but at year-end, particularly if the economy isn't doing well, a six- or nine-month delay will be appealing.

To save face, this probably would be paired with another legislated commitment to deal with the deficit later. That may be expedient, but it won't help rebuild public trust. After all, Congress set these Dec. 31 deadlines last August to try to force its own hand.

Odds: 50%.

All these odds will change before year-end.

It matters who wins in November, and how decisively. A sweep by either party lifts the odds that its approach will prevail and reduces the odds of gridlock.

It matters when the next vote on raising the debt ceiling comes. If revenue falls short of projections and the Treasury runs out of maneuvering room, it may need an increase in the limit before year-end. That timing strengthens the hand of those who want to deal with the deficit in the lame-duck session, making that a condition of their vote on the debt limit. Treasury Secretary Timothy Geithner told Congress Wednesday, "My own view is that Congress is going to have to act on this before the end of the year."

It matters what financial markets do. So far, stock and bond markets have ignored the risk to the economy of the year-end deadlines and the longer-run risk posed by politicians' inability to restrain rising government debt. Someday, the markets will notice. When they do, politicians will find it harder to defer and delay.