Don’t panic about the fiscal cliff

September 27, 2012

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


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“the Fed is effectively offering to finance whatever deficit the U.S. government chooses to run at almost no cost.” WHAT????

Posted by georgefox | Report as abusive

It doesn’t matter which way the election goes. Neither side has ever repealed anything the other has done, they just tweak it. It’s all smoke and mirrors. Either way we’ll get more laws that trample us under foot, more wasteful spending and ever closer to total State control of every facet of life. If the budget is ever balanced, there will be riots in the streets. Lets just hope that like our grandparents hoped, the can gets kicked far enough down the road that we get ours. Let the grand kids worry about theirs.

Posted by LysanderTucker | Report as abusive

Well written:

“sensible long-term program of gradual fiscal consolidation”

Taking into account we need to compete globally but while generating domestic jobs.

Posted by robb1 | Report as abusive

Very clever analysis — worth reading. Thank you.

Posted by matthewslyman | Report as abusive

“Bernanke sees unacceptable levels of unemployment and attributes them to an excess of saving over investment by the private sector.”

An excess of saving? Millions of the lower working class citizens living from paycheck to paycheck and seniors depending in the interest from their meager saving would strongly disagree!

The Fed Chairman is carving out a unique place for himself in history – but not what he expects …

Posted by ManInTheShadows | Report as abusive

In 2014, it is our best hope that Europe will have stabilised, and that gradually reviving economies in each of its states will push the EU zone government budgets into a surplus.

Given the constraints of the Euro model, it is unlikely that EU will ever attempt Keynesian stimulus on the grand scheme of the USA.

This will just leave the Anglo countries (and China) persisting with Keynesian stimulus. Only time will tell whether this will prove to be Keynesian folly or Keynesian genius.

At least China had money in the bank before the crisis started, and Australia had a structural surplus for a time.

Yet one would be hard pressed to say that the US had a structural surplus before 2008, and now with 25% of GDP being spent on Federal programs, and only 15% of GDP being raised in taxes, it also hard to say how this fits into the Keynesian model.

Posted by GrahamLovell | Report as abusive

Great article!

The Europeans have a demonstrated talent for self-destruction. And no European country has been as destructive of self (and others) as the Germans.

They’ve surpasses in their austerity madness even the new virulent strain of Republican known as the Tea Party.

Posted by jrpardinas | Report as abusive

Not so sure I agree that either party is sane enough to work together.

Posted by DPROG14 | Report as abusive

No Government can finance itself indefinitely as a kind of fiscal perpetual motion machine.

Posted by paintcan | Report as abusive

narrow minded interpretation of what is “good” for americans

bernanke’s bond buying is good for market traders

but not average joe america who does not receive a dime from their fed

article reads like a plea to extend the methadone treatment

Posted by scythe | Report as abusive

Our politicians are so confident they can borrow and print money forever, they don’t recognize its resulting hyper-inflation as the true FISCAL CLIFF. Instead they say the FISCAL CLIFF is a few upcoming cuts in their spending. Go figure.

Posted by oregun | Report as abusive

@ManInTheShadows: I believe the article is referring to the roughly $2T businesses are sitting on, in addition to the $1T banks are holding, as the “savings” that are preventing the economy from expanding. The problem seems to be not a lack of capital but a lack of customers to get businesses to begin hiring and borrowing to expand to meet increasing demand. Getting money into the hands of those who will spend it, rather than sit on it, seems to be the real challenge, I think!

Posted by bcartrite | Report as abusive

“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 ”

I’m afraid the author seriously underestimates Republican nihilism. He suggests that the motivation for obstruction will “disappear” after the election because the parties will then be faced with the necessity of governing for the next four years. However this necessity existed after the 2008 election but it did nothing to prevent the Republicans from pursuing a policy of obstruction from day one. Why should this time be any different?

Posted by chris9059 | Report as abusive