A Road Map for Avoiding the Fiscal Cliff • Has the Fed Declared War on Brazil?

Congress should reform entitlements and raise taxes to avert Armageddon

How long does the U.S. have before the bond market demands much higher interest rates on Treasuries, forcing a sudden and painful belt-tightening on every American? For a sense of the answer, tune in a week or so after the presidential election.

That’s when Congress reconvenes to decide what to do about the expiring tax breaks and across-the-board spending cuts taking effect in January. Failure to modify the tax hikes and spending cuts would almost certainly induce a recession. And if all the scheduled tax increases take effect, consumers would get crushed. The Tax Policy Center reported this week that the average increase for middle-income households would be almost $2,000.

Luckily, a bipartisan coalition of people in and out of government has been trying to figure a way out. The outlines of a consensus are emerging. Tax revenue in exchange for entitlement cuts offers the best hope. The challenge is to give each side enough incentive to withstand a backlash from its partisans.

Can it be done? As always, the hardest part will be getting Republicans to raise taxes. But even Mitt Romney, the party’s presidential nominee, says he might tax the rich more. Romney recently mused out loud that he would limit taxpayers to $17,000 in deductions; that could mean a hefty tax increase for the rich, depending on the details. With that in mind, here is a suggested 10-year road map:

• Raise the retirement age to 69 from 66 by indexing it to longevity. Adding one month every two years would bring it to 69 in the year 2075. Eligibility for Medicare benefits should also rise. Savings: $249 billion.

• Require more Medicare cost-sharing. Congress could discourage overuse by increasing deductibles and co-payments. It could also means-test Medicare benefits so that the well-to-do elderly pay more. Savings: $353 billion.

• Shrink cost of living adjustments. The consumer price index overstates the cost of living by not accounting for the cheaper product substitutions consumers make when prices rise. A better index, the “chained CPI,” captures such behavior. Savings: $232 billion.

• Raise taxes on the wealthy. The Bush tax cuts should be allowed to lapse for households earning above $250,000, returning the top marginal rates to those under President Bill Clinton. Congress should also adopt the Buffett rule, requiring millionaires to pay at least 30 percent in income taxes. Savings: $740 billion.

• End corporate tax breaks. We would end the 15 percent rate on profits earned by managers of private equity firms. Other options include abolishing a tax break for last-in, first-out inventory accounting and cutting oil and gas subsidies. Savings: $160 billion.

• Overhaul other government programs. Congress should eliminate some farm subsidies, reform the military pension system, require federal employees to contribute to their pensions at levels similar to private-sector workers, and have the U.S. Postal Service go to five-day delivery. Savings: $213 billion.

These actions would yield two-thirds of what is needed. They’d cut $470 billion from Medicare and $570 billion from other domestic programs. The tax increases equal $900 billion. Closing more loopholes, raising rates on investment income, extending Medicaid drug rebates to the Medicare drug program, and revamping the Department of Defense could produce the remainder, and possibly leave enough room to lower tax rates.

The world needs to go after the real currency manipulators — not the U.S.

Brazil’s president, Dilma Rousseff, and her finance minister, Guido Mantega, are attacking the U.S. Federal Reserve for embarking on a third round of quantitative easing. By aggressively buying bonds, the Fed aims to push interest rates lower, and that will nudge the dollar down as well.

This will hurt Brazil and other developing-country exporters, Mantega says, and what’s more, it’s meant to. To him, the U.S. has declared “currency war.”

The Fed’s primary goal, however, is not to manipulate the dollar but to expand demand at home. It hopes to do this mainly by lowering interest rates and convincing investors that rates will stay low for a good while. This should encourage consumers to spend and companies to hire and invest. If these things happen, U.S. imports will rise, and exporters such as Brazil can expect to benefit.

Although Mantega is wrong about QE3, his wider concern about currency manipulation is right. Indeed, it’s an issue over which Brazil and the U.S. should make common cause.

Let’s be a bit more precise about who manipulates currency. The charge is best limited to nations that block the movement of currencies toward levels that would help balance global trade. If currency manipulation is defined this way, the leading offender is China. One measure is a country’s growth in foreign exchange reserves: Manipulators hold their currencies down by using domestic money to buy foreign assets. Recently, and especially over the past year, China has eased this policy, but its foreign exchange reserves still stand at a colossal $3.2 trillion.

We favor adding currency oversight (and the sanctions that might go with it) to the duties of the World Trade Organization or the International Monetary Fund. This makes excellent sense because currency manipulation can add to trade policy friction and vice versa, in a cycle of mutually assured disadvantage.

Currency manipulation already violates WTO and IMF rules, but there is no enforcement. This should change. Meanwhile, Mantega and other finance ministers need to be more careful about whom they accuse of waging currency war. The U.S. isn’t among them.

To read Edward Glaeser on privatizing government agencies and William D. Cohan on JPMorgan, go to Bloomberg.com/view

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