Fiscal Cliff Notes

Some of my (somewhat well-educated) thoughts on the fiscal cliff:

1) The fiscal cliff is NOT the point at which the government runs out of money. Somehow this has become the widespread notion of what the Fiscal Cliff is, descriptively. Remember, the issuer of a currency cannot run out of that currency. The U.S. government, as issuer of the dollar cannot run out of dollars.

2) The fiscal cliff IS the point at which spending cuts kick in and tax cuts expire so that the deficit closes. That is, (G - T) becomes smaller. Every economist understands that this will hurt the economy because it contracts overall spending in the economy. GDP = C + I + G + (X-M). So if Taxes go up, our spending (Consumption and Investment) will go down and if government spending goes down, overall GDP will drop unless somehow we miraculously become a large net exporting nation.

3) Knowing this, we still think we have to shrink the deficit. I detailed this a couple of weeks ago, so I recommend reading that piece. IF we let the fiscal cliff happen, the economy will shrink quickly. If we reach a deal, the economy will sputter and will likely fall some if not a lot--it depends on the magnitude of the deal.

4) We need a larger deficit! This can be accomplished through spending increases or tax cuts, but the only way to actually shrink the deficit is to increase GDP. The private sector is still deleveraging, the foreign sector--our trading partners--is in poor shape, and so the only institution that can help is the government. Otherwise we're in for a long, slow deleveraging period--see The Great Depression. This is needless because the government has policy tools to prevent it, and it doesn't necessarily have to mean a concentration of government power.

5) What we spend money on matters! Some spending has a higher multiplier effect or employs more workers. Much spending is extremely wasteful and so wouldn't do much to help our society or our economy. All spending will benefit some more than others. Some spending is immoral. We need to make these decisions as a society in the political arena, but note these decisions have economic effects--see my most recent post on this.

6) We have a particular duty to look out for those left behind or trampled on by the system. We can do this personally and through institutions--including Churches, non-profit organizations, local governments, and the federal government. All have advantages and disadvantages, but all are needed according to the principle of subsidiarity, which is not a limiting principle (thinking of it solely as a principle that limits the size of government), but is rather a cooperative principle (thinking of it in terms of all institutions of all sizes working together to accomplish the common good).

7) Gutting programs that benefit the poor for the wrongly perceived reason of the inability to afford them would not be beneficial to the poor. We can argue over whether these programs are good for the poor aside from affordability, but that is the reason invoked by both parties and it is quite false.

8) At a time of insufficient aggregate demand, why not give the poor more money to spend? They need it the most and are most likely to spend it, which would stimulate the economy.

9) Insufficient demand essentially means that government spending is too low or taxes are too high. This is because they are the issuers of that which we use to demand things with, so they are keeping the supply of 'demand signals' too scarce. So instead of raising tax rates as Obama wants to do, why not just get rid of the highly regressive, middle-class and small business punishing payroll taxes?

10) State budgets were hit hard by the Great Recession and many public employees were let go. Why not give each state a block grant per capita to spend on preventing those cuts (or in this case rehiring those cut) to many useful jobs including teachers, police officers, first responders, etc.?

11) When the economy gets back to full employment and the distortionary (is that a word?) effects of inflation start to rear their ugly head, we will need to cut the deficit down if it doesn't do so on its own. If the increase in income taxes cause by an increase in income doesn't reduce the deficit enough to slow inflation, then the government will need to raise taxes or cut spending to curb inflation--assuming of course that this is demand pull inflation. Cost push inflation is a real constraint (as opposed to monetary constraint as is demand pull inflation) and is much more difficult and much less pleasant thing to deal with.

12) My prediction is that a deal will be reached just in the nick of time, but before that happens markets will get spooked that a deal won't happen and will panic causing potentially large drops in the stock averages. This will also cause drops in spending due to increased uncertainty among businesses and households. A credit rating drop might trigger this kind of event. But, again, it doesn't mean that we can go bankrupt, but that we are threatening to not make payments we have agreed to, effectively declaring needless voluntary bankruptcy. After the deal is reached we will return to a "barely there" growth economy or will fall into a sputtering economy of no growth or a little negative growth--again it depends on the magnitude of the deficit cut. The deal will also likely mean greater income inequality and poverty, and worsening political divisions with Republicans blaming the slow economy on the increase in tax rates on the rich and Democrats blaming cuts in entitlement programs. We will see if my prediction comes true, but I make this recognizing that there could by many mitigating factors, and frankly, I hope I am wrong--I hope we figure out that we need more demand and that we give it to those who need it most.

UPDATE:
13) Oh, and the debt ceiling should be eliminated. It is completely arbitrary and totally useless. The U.S. debt is the world's (that is, all those people who hold treasury securities) savings in the U.S. dollar of account. So as our economy grows, we should expect our savings to grow, which means that the debt will go up forever! That ticking clock in Times Square that goes up and up and up is a good thing! If we set an arbitrary ceiling on the debt, we effectively set an arbitrary ceiling on our economy, because without the financial savings--the safe assets--we cannot sustain any real growth. (Again, this says nothing of the size of government, because bigger debt does not equal bigger government, it just means a larger stockpile of accumulated treasury securities--a good thing!).


But what are your thoughts? I want to know! Post a comment below!