The two ways this could go

While the nation’s capital burns with gossip about David Petraeus and his love life, the fiscal cliff is not far away. I don’t often wade into the waters of broader federal budgeting, but people are beginning to explore the endgame of this Beckettian drama and a few wonder about its implications for the defense budget. Defense is just a residual issue here; the big top is focused on revenues and entitlements.

Paul Krugman says the whole cliff fracas is a diversion, especially at the leading edge of a recovery; keep spending until the economy is healthy.

Unfortunately, the political system and the march of law and time are inexorable. Those pesky Bush tax cuts expire at the end of the year, so something must be done, either to extend them or to split them in two, the way Obama proposes: families with over $250,000 of income get a higher rate — up from 35 percent to 39.6 percent — while everybody else keeps the lower rates in the original legislation.

A few other items are lying around, needing urgent repair before damage is done. The Alternate Minimum Tax is not indexed for inflation, so more middle-income families (including yours truly) will get whacked next April, unless the AMT is at least "band-aided" for the 2012 tax year. America’s doctors are surely going to lobby against letting their Medicare reimbursements fall, which happens at the end of December. It seems like very few Americans are going to lobby to perpetuate the 2 percent reduction in the payroll tax for Social Security, so maybe that is gone; the same may be true for the extension of unemployment benefits, now that the economy is headed to recovery.

The long poles in the circus tent are sequestration, the likelihood that we will again bump up against the debt ceiling toward the end of 2012 (with Treasury vamping to postpone the problem into February), and the threat of a government shutdown on April 1, in the absence of final appropriations.

The debate is all about these issues, especially whether the White House and the Republicans in the House are prepared to put the biggies on the table: revenues and entitlements. Defense is the side-show, even though the "defenders of defense" have danced up and down for more than a year, trying to make it the main event.

It seems to me likely that one of two scenarios plays out over the next six weeks (or 14 legislative days, if you count that way). Either way, it will be sausage, not a Grand Bargain.

Option One: Dive off the cliff. The president lets the tax cuts expire and sequester happen. The Office of Management and Budget defers the impact of the sequester by apportioning funds to agencies at the level appropriated in the current continuing resolution (which goes until March 27, 2013), so spending does not actually take a whack right away.

The new Congress comes in and starts with the functional equivalent of a clean slate — tax rates have gone up, the sequester has happened (but the impact is deferred). They start a new round of talks with the president, leading to an agreement that kicks the can down the road. The agreement is a framework on the issues that matter: revenues and entitlements. The framework sets targets for both, raising revenues and lowering entitlement spending projections. But there are no details: these are left to the Senate Finance Committee and the House Ways and Means Committee to fill in by a given deadline. Over to you, David Camp and Max Baucus.

In this scenario, discretionary spending is a residual issue. Perhaps the agreement lowers the "caps" set out in the Budget Control Act of August 2011 to make the numbers work. Defense dollars fall below the numbers projected in the current caps. David Leonhardt thinks so; so do I.

Advantages of Option One: it sets new baselines for revenues and for discretionary spending. Anything the next Congress does to change those baselines looks good, because Congress can claim that it lowered taxes (from the new baseline) and that it raised spending (from the baseline).

Disadvantage: The markets may not be happy, sending the stock market into a tailspin nobody wants.

Option Two: this same deal is reached before the end of the December. Disadvantage: the new Congress is cut out and there are no new baselines for revenues and discretionary spending.

Advantage: the markets like the agreement and the recovery appears to continue. It has the same effect on discretionary spending: it is a residual. To get the overall number, defense still goes down below the current caps, possibly even in FY 2013.

Either way, from the view of someone in the defense business, the consequence of defense being a side-show, with reductions needed to get the whole package to line up with the existing or new spending targets, is that defense budgets continue to go down.

Just what I always thought.