Who’s afraid of the fiscal cliff? Even as protests in Spain and Greece revive jitters in the euro zone, global businesses and investors have discovered a new political horror, this time in the U.S. The fear now in world markets is not so much about November’s election, but about the automatic tax hikes and public spending cuts that Ben Bernanke has dubbed the “fiscal cliff.” These fiscal changes, which come into force on Dec. 31 unless Congress passes new legislation, will tighten fiscal policy by some 4 percent of GDP, comparable to the austerity programs in Spain, Italy and Britain.
Given what fiscal austerity has done to Europe, the worries are understandable, but everyone should calm down. A drastic fiscal tightening is almost inconceivable after the election, because politics, economics and markets interact in Europe and America in opposite ways.
Let’s start with economic policy. The warnings from the Federal Reserve to U.S. politicians as the fiscal deadline approaches are all against allowing the legislated tax increases and spending cuts to take effect. Thus the Fed is giving politicians advice that is opposite that of the European Central Bank and the Bank of England.
Moreover, the Fed is now putting its money where its mouth is. By warning the U.S. government not to tighten fiscal policy, and simultaneously promising to buy bonds and to keep short-term interest rates at zero until the economy returns to full employment, the Fed is effectively offering to finance whatever deficit the U.S. government chooses to run at almost no cost.
In terms of economic philosophy, the Fed is now a clearly Keynesian institution. Bernanke sees unacceptable levels of unemployment and attributes them to an excess of saving over investment by the private sector. He therefore wants the government to keep borrowing until the private sector returns to normal levels of investment and spending – and promises to finance this borrowing with printed money. This policy is anathema in Europe, especially in Germany – so much so that EU treaties explicitly make “monetary financing of government” illegal.