Don’t panic about the fiscal cliff
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.
The opposing economic philosophies of the Fed and the ECB are reflected in financial market pressures. In Europe, bond markets attack countries that persistently overshoot their fiscal targets or get downgraded by rating agencies, knowing that the ECB will punish such “profligate” governments. But global investors continue buying U.S. Treasury bonds regardless of how much the Congress borrows, safe in the knowledge that the Fed will keep short-term interest rates at zero and will support bond prices.
Because of this newfound Fed support, the “bond market vigilantes” who used to terrify Jimmy Carter and even Bill Clinton have vanished. And rating agencies that threaten to downgrade the U.S. government’s credit have become a laughingstock. Indeed, when one of these agencies did remove the U.S. triple-A rating last year, the price of Treasury bonds, far from plunging, actually went up.
Which brings us to politics. With the Fed warning in the strongest possible terms against any immediate fiscal tightening and with bond markets applying no pressure on the government to reduce its borrowing, why shouldn’t the Congress and president simply postpone for another year all the tax increases and spending cuts due on Dec. 31? Having avoided the fiscal cliff, why don’t the politicians then sit down and work on a sensible long-term program of gradual fiscal consolidation starting in 2014, as recommended by Bernanke and almost every other sensible economist? The answer is, of course, political polarization – and uncompromising partisanship could surely push the U.S. economy over a fiscal cliff. But how likely is an all-out political confrontation between the election and Dec. 31?
If Mitt Romney wins, it is inconceivable that a defeated President Obama and lame-duck Congress would blatantly sabotage the economy, defying the Fed’s explicit warnings and a newly elected president’s appeal simply to delay decisions until the new government is in power. In the unlikely event that the Democrats did attempt this affront to democracy, it would have no impact since investors and businesses would know for sure that any tax hikes and excessive spending cuts would be reversed within days of the new president’s inauguration.
But what about the more likely scenario that President Obama is re-elected, while Republicans continue to dominate Congress? This might mean more paralysis, but that is not the same as economic suicide. If we extrapolate from the politicians’ previous behavior, we would get procrastination until midnight on Dec. 31 and then a vote to postpone any major decisions for 3, 6 or 12 months. Pushing the economy over the fiscal cliff would require much sharper polarization than ever existed before the election. That is extremely unlikely, because the cost-benefit analysis of simply “kicking the can down the road” for another six months or so will change abruptly after Nov. 6.
Before the election, the main cost of postponing decisions was the political embarrassment of failing to exercise leadership and the risk of triggering a rise in interest rates. The main benefit was avoiding immediate damage to the economy.
After the election this calculation completely changes. Members of Congress sitting in the lame-duck session before Dec. 31 will be acting democratically by passing responsibility for major fiscal decisions on to their duly elected successors. And the Fed has removed the threat of higher interest rates. The costs of postponement have thus vanished.
Meanwhile, the benefits of protecting economic recovery have hugely increased. Before the election Republicans could reassure themselves that any economic damage caused by obstruction would be negated by the benefits of unseating President Obama. But after the election, this motivation will disappear. Instead, both parties will face the inevitable prospect of living together for four more years and will be held responsible by voters and business funders. Neither side will want to start this long period of uncomfortable, but unavoidable, cohabitation, by pushing the economy over a fiscal cliff.
PHOTO: A competitor jumps into the water during a cliff-diving competition near the central Bohemian village of Hrimezdice, August 4, 2012. REUTERS/David W Cerny