Now that the elections are over, we are sitting less than two months away from what I would consider a catastrophic budget resolution. It is politics, not economics that has dictated the fiscal cliff – and I suspect unfortunately that it will be politics again, not economics that determine what the solution will be.
The fiscal cliff won’t happen, I say that will almost 100% certainty. But what will happen is that congress will vote (probably after an extension) on some fairly large budget changes. These will be to raise taxes and cut spending, with the majority of the deficit reduction plan coming from spending cuts.
The idea, is that by raising taxes and cutting spending you signal to markets that you are a safe investment which further drives down interest rates. Well… that was the idea when Clinton did it. We live in an entirely different world today. This notion is often referred to the ‘Confidence Fairy’, made popular by Paul Krugman. Confidence does play a role in markets, we see it all the time, the reason our Fed Chairman Ben Bernanke comes out and says our fundamentals are good, or pre-crisis that our banks were fundamentally sound (which we found out later was not always the case) is to steer markets and keep the system afloat.
In the case of today however, confidence has been largely restored. The lack of confidence has come only as a result of political bickering and less so because of our deficit. Sure, it has gotten out of control, but in a recession we would expect it to be. The medicine is there, we can take it when we need it, but now its better to let nature take its course.
Lets get back to what the real problem is with this idea. To bolster sustained economic growth, the Fed prefers adjusting the Federal Funds Rate. Right now, interest rates are close to zero. You can’t get much lower than that. Instilling confidence isn’t going to have as big of an effect on lowering these already low rates. If the economy grows, as it appears to be on track of doing so, we would naturally see nominal interest rates rise. This gives the Fed room to work. The alternative is far from ideal, more Quantitative Easing, which the Fed is not comfortable doing on a large-scale due to inflationary pressures.
What threatens growth is the crux of the problem of this sustained economic growth. Spending cuts and tax increases, if done without much thought of their effects on economic growth can act to destabilize an already fragile recovery. Even cuts having only a short-term effect further prolong the inability for the Fed to play with interest rates.
With interest rates close to zero percent, negative in real terms, spending cuts may be very ill-timed. Another problem we have centers around what is called the ‘fiscal multiplier’. The idea of the fiscal multiplier is that for every change in spending or tax receipt the output in the country changes by this proportion. If the multiplier is 1, a $1 cut results in a $1 loss in economic output. Today, our multiplier may very well be greater than 1. Spending cuts that threaten to bring growth down which will then prompt monetary easing, limiting the multiplier – which lowers economic output for every dollar spent.
The argument championed by economists is that, with scarce capital (money) the government effectively crowds out private sector investment and expansion when it spends more and more of the scarce resources. This would have a negative effect on growth assuming that private investment is more fruitful than public (and it is). Where this argument is invalid though is in current reality.
We are being flooded with capital, banks are sitting on more cash than they know what to do with, the markets are almost begging for us to borrow. We aren’t in that situation where we are fighting over scarce capital, the idea we are stands logic on its head. So the idea that cutting spending or raising taxes to make the market love us, is one of just pure ‘idiocracy’.
So the tightrope that the government is going to have to walk, which they probably wont, is that of cutting programs and raising taxes on things that do not largely affect growth. But in doing so, they would be smart to also appropriate funds towards things that result in growth. Raising taxes on the wealthy for instance, and using those funds to build infrastructure or invest in R&D would be smart plans of action.
Failing to do so risks stagnating the economy, and severely limits the strength of recovery – at least in the short-run.