Friday, December 14, 2012
Falling off the Fiscal Cliff
Everyone is talking about the fiscal cliff, maybe not exactly everyone. Those who are talking about the fiscal cliff are “naturally” our policy makers and the media guru. One expects our policy makers to make “hay” about the so called cliff, but the pundits in Washington and just about anywhere they can hook up a so called commentator to the phone or to a TV camera the news makers are having a field day about the so called fiscal cliff.
Before getting into the nitty-gritty of what the fiscal cliff is all about and where the country is heading, off or on the cliff, let me backtrack a little and talk about the ingenuity of the label—the FISCAL CLIFF. It sounds ominous, or does it? The first time I heard of the term--the Fiscal Cliff, I had this image of those superb divers in Acapulco Mexico diving from extreme heights off a cliff. None, at least to this viewer have suffered ill consequences of a dive, but it obviously takes skill, stamina and fortitude for a diver to achieve such an exhilarating and superb dive. So what will it be like to fall off the Fiscal Cliff: will the economy survive the fall? What is at stake?
To put the issue in some order let us begin with the label. Obviously there is no such thing as a fiscal cliff; it is a metaphor, which is ascribed to one of our illustrious policy makers. When I heard the term, I presumed that someone either in the popular media, or a talk show host coined the phrase. A bit of poking however, identified the source. According to Wikipedia, the term “Fiscal Cliff, if not invented by our illustrious Chairman of the Federal Reserve, it was popularized by him. Stan Collender in a blog posted 12/07/2012 identified the source. He attributes the phrase to Ben Bernanke the chairman of the Fed. He goes even further to note that Alan Greenspan, the former chairman of the Fed “would have been proud of the Ben Bernanke-coined fiscal cliff”; he goes further to postulate that Greenspan himself would have used the phrase. But would he?
I raise the question as a graduate teacher of macroeconomics and public economics for more than a quarter of a century. Our books and articles are rich in models, theoretical and empirical about the macro economy, the public sector, its budget posture, the budget deficit, the aggregate as well as the structural and cycle adjusted deficits, the “equilibrium” level of debt to GDP and so many other thesis about the debt/GDP ratio and the implications of this ratio for the stability of the economy. Nowhere in our arsenal do we label a parameter value indicative of either the Deficit/GDP ratio and or the Debt/GDP ratio as something akin to a fiscal cliff. But then “Who” would have listened if economists would explain the equilibrium value of these ratios and the dire consequences if these ratios exceeded their equilibrium values. The term fiscal cliff whether coined by the Chairman of the Fed or popularized by him, caught the imagination of both the policy makers and the news establishment—it is more ominous to fall off a cliff than to fall of an equilibrium formula developed by economists.
Now that you know, that you are not likely to find the term “Fiscal Cliff” at least in macroeconomics, and public economics books and articles vintage 2011 and earlier, let us make some economic sense of what the “cliff” is made off, who is ready to jump, the players who would like to push the other team off the cliff and whether it really matters in the “longer-run” whether the jumper survives the jump or simply hang in there waiting for the next jump.
For a start, there is indeed a critical value for the federal debt to the gross domestic product (GDP), beyond which the national economy suffers adverse economic consequences, put in current terminology: “falls off the cliff”. What is this critical value, and why is it said that the economy falls off the cliff. To make sense of this claim, key economic principles are in order.
The national economy consists of three major components: Consumption, investments and government. These three have activities we refer to as consumption, investment and government spending. Consumers and investors generate activities and products hence income that enable them to consume, save, produce and invest. Unlike consumers and investors, government has no income of its own (of course there are some assets, but these assets are not sufficient to fund its activities), thus the government has to acquire the resources (income) from someone—consumers and investors. Taxation is the method all governments use to transfer income to themselves. The transfer is done through taxation whether a direct tax such as the income tax or an indirect taxation such as excise tax, or sales tax. If the taxes imposed are sufficient to cover government expenditures there will be no need for further transfer from the private economy to the public economy, in other words there will be no public debt.
But then few of us are debt free, so why should the government be? Households borrow to finance the purchase of assets, such as homes, their children education and the like. Borrowing is made possible because the lender evaluates the future capability of the borrower and if sound they lend, if not they do not. Most borrowers are careful not to exceed some critical value: the ratio of debt to personal income (debt/income), for if this ratio is exceeded, not only their credits will be cut off but they may slide off their own cliff.
The same scenario applies to the federal government—its take falls short of its spending. True the government has a better access to funds, its credit rating, until 2011 was superior to most of us borrowers and the universal faith in its ability to pay its debt was unshaken. But then came the summer of 2011 when the battle of the debt ceiling was waged and almost lost. The fiscal cliff is linked to this battle.
Let me backtrack a bit and talk about where we got here from there. As I mentioned earlier there is a critical value of the debt to GDP ratio. A great deal of economic modeling has come up with a value of this ratio: The ratio (debt/GDP) cannot exceed 60%. This is the ratio adopted by the European Union (one of the Maastricht criteria for membership). When and how far the US has departed from this ratio will be taken up below.
Taking a look at the recent history of the federal budget one cannot help but wonder at the way the budget posture slid out of control over a relatively short span of time. If economists’ debt to GDP ratio was a marker to be taken seriously, it is quite apparent from the progression of this ratio that the day of reckoning is not too far away. Going back to 1980 the ratio of federal debt in the hand of the public to GDP was 42.3%, the ratio began creeping upward a bit slowly over the 1980’s and the 1990’s decades reaching 50% in the year 2000. The explosion of the federal debt took place in the following 10 years. The first danger signal appeared in the year 2008 when the ratio reached 70%, at present (2012) the ratio is 102%.
One reason that the danger was ignored is the status of the economy. By now everyone knows how difficult the year 2008 was; the economy was in a “recession”, the financial system was in disarray, and a responsible public sector could not remain on the sideline. Economic advisors had to invoke the Keynesian remedy of pumping money to stimulate aggregate demand, hence the stimulus packages. The cost of course is a rise in the federal debt—no advisor at that time would have argued for tax increases to fund the stimulus packages, although some advisors, outside the policy clique argued for restraint. Given a persistent high rate of unemployment, the “prevailing wisdom” was to throw good money after good money—more stimulus and more debt. Economists of the Keynesian tradition would argue that the stimulus cost is a price worth paying, for without the stimulus the recession would worsen and the recovery date would be further away. The optimistic view, not necessarily the consensus was that once the economy began to recover, economic activities will pick up, taxes rise and support payments such as unemployment compensation would fall. Under this scenario, the debt/GDP ratio would begin a downward slide toward its “efficient” value.
Well this did not happen. In 2012 and the coming year of 2013 a reality show is in the offing. A few numbers at this point are in order.
To understand what is at stake one needs to be appraised of the imbalance in the federal budget. Looking at the ratio of federal debt in the hand of the public to GDP in 2011, and the ratio of federal taxes to GDP in 2011, it is not surprising that the economy is poised to jump over a cliff, fiscal or otherwise--the deficit/GDP (8.5%) is almost as much as the federal tax revenues/GDP (8.5%), can anyone of us be able to sustain this kind of behavior? Well so far the Federal Government, with the acquiescence of Congress was able to do just that. Now we face, I believe more than the proverbial CLIFF.
Remember that when either a household or government borrows to finance “current” expenditure, the debt incurs interest charges. These charges have to be paid from current income, and if current income is not sufficient to cover the spending plus the interest on the debt, further borrowing takes place and the debt incurs additional interest and the debt accumulates as well as the interest charges. In the case of the individual the lender may extend the repayment date, increase the interest charge and or downgrade the borrower “credit score” foreclosing on whatever asset the borrower has and/or driving the borrower to bankruptcy. The situation is similar for the government except that the government has no asset to be ceased, and most importantly the economy cannot function with a bankrupt public economy. One thing that differed in this scenario with respect to the borrowing of the government versus the borrowing of the household is that the rules are different; the government cannot increase the size of its debt unilaterally—there is a debt ceiling imposed on the federal government borrowing that cannot be exceeded without congressional approval. This is the battle that was fought in the summer of 2011 giving rise to the “Mandatory” tax increases and spending cuts in the Simpson-Bowles blue print of fiscal reform.
The battle over raising the debt ceiling in 2011, gave impetus to the creation of the National Commission on Fiscal Responsibility and Reform. The underlying reason behind the creation of this Commission is to draw a line in the sand: if neither the President nor Congress has the will or the ability to fix the Debt problem then they faces a legal biding resolution which takes off their hands the discretion over tax increases and spending cuts. The path for spending cuts and tax changes embodied in the Commission recommendations would take effect as of January 1, 2013. Facing the prospects of a deadlock on raising the debt ceiling, both the President and Congress had a temporary respite from the fight over the debt ceiling, in the expectation that once the presidential election is over, a new leaf is turned—the winner can bargain more forcefully about which expenditure cut should be legislated and which tax increase or reduction should be the order of the day. The expectation (at least in my view) was that, the Commission’s recommendation will serve only as a guide to policy making in the 2013 and beyond, that the new president and Congress will iron out their differences and come up with a “rescue” plan that takes down the path of the debt to GDP from its current unsustainable level to something closer to its “”efficient value”. The club that the commission held over the executive and the legislative branches of government is a powerful one. No matter what the election results turned out to be, a compromise has to be worked out between the two branches of government to put the debt/GDP on a downward path toward a sustainable ratio. Failure to do so, it is said that the COUNTRY WILL GO OFF THE CLIFF”. In terms of economics, the expiring Bush tax cuts and new tax increases along with spending cuts (sequester) in entitlement programs as well as defense amounting to some $600 billion will take effect as of January 2013. Falling off the cliff then means that a fall in aggregate demand due to the fall in private spending (consumption and investment) and government spending on defense and nondefense will be a drag on the economy which (under all reasonable forecasts) will cause a rise in unemployment and a decline of GDP growth, even a recession.
With the current experience with unemployment, the fall in income and the rising disparities in the distribution of income, the consensus is that no one wants to see a return to a 9 or 10 per cent rates of unemployment, a collapse in the housing market and a reduction in the safety net.
If all agree that falling off the “cliff is the worst policy outcome” why the deadlock over budget and debt policy.
The president will not submit his budget until February 2013, or thereabout, after the inauguration of his second term. The Simpson-Bowles Commission recommendations take effect January 1, 2013. Congress is supposed to adjourn December 14 (although the likelihood is that they will not do so in the expectation that a compromise will be worked out before the beginning of the year).
Given these constraints you would have thought that both the legislative and the executive branches of government would NOT HAVE SIGNED ONTO THE WORST POSSIBLE OUTCOME (The Simpson- Bowles).
By now, most individuals are apprized of the contents of Simpson- Bowles’ Commission ‘s legislation, although some may be more aware than others of how the implementation of their provisions would affect their personal finances. Two things that stick out in the mind of most people are that: their taxes will rise and those who are beneficiaries of Medicare will see their benefits eroded. What is clouding the debate over the so-called fiscal cliff is the tax issue. During the months and months of campaigning for the Presidential election, one group of population was bid against another—the 2% versus the so-called 47%. The president insisted that no deal with the Republican in Congress will be made unless the taxes of the 2% high-income group are raised. The Republicans, whose party believes that higher taxes adversely affect investment, are against taxes on those most likely to invest—the top 2%. Since neither the President nor the speaker of the House of Representatives are willing to let this issue remain dormant until next budget season, or find a middle way, the Simpson- Bowles option may not be a bad deal for either.
Let us pose a minute to think about the Simpson- Bowles plan:
First, the President wants to remove the Bush tax cut from the top 2%. The plan does away with the Bush tax cut for all including the top 2%. Without doing anything the president would fulfill his campaign promise. What about the Republicans in Congress? Everyone knows especially their constituents that “Republicans” oppose tax increases. So, lacking a compromise where the Speaker has to bow to the President demand and accept tax increases on the top 2%, he is in a better position with his party—the president forced the issue, refusing to compromise, and the tax increase on the top 2% is not of his making.
Second, take the recommendation that entitlements have to be cut and reformed. The President finds a way out of facing constituents who have overwhelmingly supported him during the Presidential election. The President can blame the Republicans in Congress for failure to negotiate, and avoid making the tough choice of enumerating the cuts to the entitlements program.
What about the Republicans in Congress? They too will get what they vowed to do: cut and/or reform the entitlement program. The Simpson- Bowles recommendations accomplish the objectives without the Republicans in Congress appearing to be anti- the old folks.
What of the Fiscal Cliff?
If you think about it, no matter what plan is put in effect, the economy will “stagger” through the next few years, with a modest if not small growth until the budget posture improves and the debt/GDP ratio retreats to its “efficient” level.
The Fed Chairman in his news conference yesterday (12/12/2012), although stating that the Fed does not have in its “arsenal” tools to offset the expected adverse effects if we go over the “fiscal cliff”, he nonetheless outlined Fed policy that would certainly ameliorate the predicted adverse outcome. One tool in the Fed arsenal is liquidity. He stated that the “federal fund rate” will remain near the ZERO level until the unemployment rate reaches 6.5% or lower. This is a novel principle as the Fed has not in the past targeted the unemployment rate. Moreover, the Fed announced that they will increase their holding of assets effectively increasing the quantity of money. Economists may debate the potency of fiscal versus monetary policy, but the fact the Fed acted indicates that the Fed will not remain passive if the economy were to go over the so called Fiscal Cliff. Of course time will tell if we were to fall off the Cliff or go around it.
Attiat Ott, Ph.D.
Research Professor, Clark University, Worcester, MA
President, Institute for Economic Policy Studies, Worcester, MA