Ruminations, December 9, 2012
Is the fiscal cliff so bad?
***Yes. And no. That about covers it — unless we need to examine why it is bad and why it may not be bad in the long run.
What is the fiscal cliff? The fiscal cliff consists of two separate yet related programs: sequestration and tax cuts. Sequestration is part of the Budget Control Act of 2011. As enacted, automatic spending cuts kick-in in 2013. Sequestration was enacted to put pressure on Congress and the President to act before the deadline (January 1, 2013) to put into place a rational program of spending and taxes so as to reduce the deficit. (Some may say it’s an oxymoron to use “Congress and the President” in the same sentence with “rational” but there you have it.)
What’s bad about the fiscal cliff? In the first place, the fiscal cliff upsets the status quo economic situation and that’s bad. An integral part of economic expansion is predictability. Entrepreneurs and captains of industry will hold back on expansion and even reduce plans if they can’t anticipate the economic climate and hence the demand for their products. Certainly the fiscal cliff will reduce economic predictability. Further, because we have heard again and again that the fiscal cliff will hurt the economy, we have come to believe it, even if we don’t understand it, and we will behave accordingly, ensuring that the economy heads into another recession.
Americans are remembering the financial crisis and Great Recession of just five years ago, and, hearing that the fiscal cliff may cause another recession, are becoming frightened and cautious. Don’t believe me? Here’s what Robert Samuelson wrote two weeks ago in The Washington Post: “The financial crisis and Great Recession scared the wits out of most Americans — not just consumers but also corporate managers, bankers and small-business owners. They are reacting accordingly. They’re cautious, risk-averse and defensive. They’re spending less and saving more.” Spending less and saving more may be good for us individually but on a macroeconomic level it hurts the national economy.
What happens with sequestration? It seems that everyone is aware that this country is spending far more than it takes in in revenue. Our debt is an unimaginable $16 trillion. We know that that number must be reduced and the only way we can reduce the $16 trillion is by running up a surplus. And yet, the deficit for 2013 is estimated to be on the order of $1.37 trillion. It’s going the wrong way: The debt is getting bigger.
If we go over the fiscal cliff, sequestration will cut the deficit for 2013 by $109 billion. It’s still going the wrong way, but more slowly.
One of the greatest drivers of stock market performance is the psychology of market investors. If, as we’ve been told and believe, sequestration represents the worst outcome we can expect, the market will drop dramatically. That will drastically reduce the wealth of most Americans and drive down interest rates below their miniscule current rates.
Tax cuts. Also discussed in conjunction with sequestration (which begins January 2, 2013, unless Congress and the President do something) are the Bush tax rates (which are scheduled to expire December 31, 2012 unless Congress and President do something). And the expiration of the Bush tax cuts will raise taxes on everyone – not just the other guy. This will depress spending and investing, which will depress job creation and, as a direct result, will increase government spending on the safety net (e.g., unemployment compensation).
What’s good about sequestration? It would put us on the path to financial stability by reducing the deficit and probably result in a credit rating upgrade. Last year, both Standard and Poor’s and Egan-Jones Ratings downgraded the U.S. credit standing. This, as of yet, has not had any material impact on the U.S.’s ability to borrow money, but it probably will sometime in the future. In addition, the Fed’s penchant to push down interest rates by printing more money could be lessened, since the attractiveness of a reduced deficit would help keep rates low.
If the Bush tax rates are allowed to expire, what would that mean on the positive side? Well, according to the liberal Citizens for Tax Justice (CTJ), the Bush tax cuts cost the national government $2.5 trillion over 10 years. Now, the CTJ does not take into consideration that tax cuts usually result in behavior change and as many, including this column, have claimed, tax revenues actually increased due to changes in taxpayer behavior caused by the Bush tax cuts.
If CTJ is right, it would mean that the tax expirations would help us move toward fiscal stability. At the same time, it would accelerate the move toward recession and mayhaps make the recession much worse.
If CTJ is wrong, it would mean tax revenues go down and it would accelerate the move towards recession.
An analogy. Let’s try an analogy. You have gangrene in your little toe and the doctor wants to amputate, which will be painful. But instead, you can take some pain-killers and postpone the operation. You choose pain-killers. As time goes by, the gangrene has spread to your entire foot. You can now amputate the entire foot or take more pain-killers and postpone the operation. You choose more pain-killers. Eventually, the gangrene spreads through the entire leg and threatens your life. You can choose the painful operation or take more pain-killers and die.
In this analogy, gangrene represents cuts in government spending and programs. They will be painful as will sequestration. But the patient (the United States) will survive. Or we could choose more pain-killers, i.e., borrowing more money.
Just as the patient in this analogy, we can’t live on pain-killers forever. At some point we need to do some amputation. And the longer we postpone it, the more painful it will be.
What to do? It seems that the best choice at this time is to allow some significant budget cutting or sequestration to take place. We all, no doubt, oppose one part of sequestration or another, but we need to start somewhere. At the same time, we should extend the Bush tax cuts – if not extended, the tax base will shrink and our ability to shrink the deficit along with it.
If it is necessary to compromise on taxes to get significant spending cuts, so be it. It will be painful but not nearly as painful as it will be in the future.
Quote without comment
The late Friedrich von Hayek, Austrian economist, in an interview with The New York Times, December 1, 1982: “The only way you can finance deficits is by inflation. You cannot raise this amount of money by genuine borrowing. You borrow from banks, which create credit for the purpose. A large government deficit is a certain way to inflation.”