Opinion

The Great Debate

The perils of cliff-diving

By Douglas Holtz-Eakin
December 6, 2012

The fiscal cliff is a danger to the economy.  Some have argued that cliff diving is benign either because the cliff itself is an illusion – it is really a gentle slope – or because policymakers have the cartoon-like power to reverse going over the cliff without hitting the abyss.

Both arguments miss the key role that would be played by financial markets.  Cliff diving would have a significant impact on financial markets, impairing asset values, exacerbating credit stringency and amplifying the direct effects on the Main Street economy. These effects cannot be “unwound” by retroactively legislating away the fiscal cliff.

Taken at face value, the fiscal cliff is a large negative policy shock.  The tax increases are nearly $400 billion and the spending cuts about $145 billion.  The total, $540 billion is roughly 3 percent of gross domestic product.   For perspective, trend economic growth now appears to be less than 2 percent — but certainly nowhere close to 3 percent.

If one uses the multiplier estimates of Christina Romer and Paul Romer – roughly three – going over the fiscal cliff would trigger a decline in the economy of $1.6 trillion – roughly 10 percent of GDP. This would be biggest year-to-year decline since 1932.

But there are good reasons to take that with a grain of salt, however. First, the size of multipliers is controversial, and they may be much smaller.  But even a multiplier of 1 yields a $540 billion decline – a recession of 3 percent.

Second, the duration of the recession is unclear. If Congress adopted a new fiscal policy quickly, the recession could be short-lived.  So, for example, a 3.5 percent recession at an annual rate that lasted only through January, and was quickly reversed, would be a mere blip on the economy’s growth path.

Taken together, these arguments raise the hope that going over the fiscal cliff could be reversible and have a modest overall effect.  Unfortunately, the potential for significant financial market fallout substantially changes the outlook for cliff diving.

Financial markets react essentially instantaneously.  Hence, the moment it becomes obvious that the economy is going over the cliff – recall the horrific sight of the markets crashing as the TARP vote failed – we should anticipate that equity markets will fall, and the riskiness of various classes of debt will be re-evaluated.

Unlike budgetary moves that can be reversed, these kinds of negative effects on market confidence in the outlook are durable.  Many analysts, for example, attribute at least part of the slowing in the 2nd half of 2011 to a decline in consumer confidence because of the political battle over raising the debt limit.

Thus, if policymakers drive the economy over the fiscal cliff, the pure multiplier analysis on the real economy should be augmented by negative financial market impacts that are potentially quite large and long-lived.

The real danger of a renewed recession raises the stakes on reaching a deal. It even shapes the kind of deal that is desirable.

Congress and the president should reach a grand bargain that trims the future debt – next year.  For now the focus should be on temporarily extending current policy, dodging the cliff dive — and averting a self-inflicted recession.

PHOTO (Top): The Dow Jones Industrial Average on a board at the New York Stock Exchange at the end of the trading day, October 15, 2008. Wall Street had its worst day since the 1987 stock market crash. REUTERS/Brendan McDermid

PHOTO (Insert): A weary trader outside the New York Stock Exchange at the end of trading October 9, 2008. The Dow dropped 678.91 points that day to finish at 8579.19, closing below 9,000 for the first time since 2003. REUTERS/Mike Segar

Comments
9 comments so far | RSS Comments RSS

Let me rephrase one sentence to straigten out the numerous errors in your propaganda article.

“Congress and the president should increase taxes on the wealthy, which have caused all of this because of their unmitigated greed, and force them to pay their fair share – beginning next year.”

Without more revenue coming in, the US economy WILL certainly crash.

This is not a debt issue. It is a shortfall in revenue issue, which is caused solely by the wealthy refusing to pay their fair share in taxes.

It’s not rocket science, if people like you would begin to tell the truth.

It’s also not economics.

It’s old-fashioned greed by the wealthy class who care about nothing but themselves and maintaining ther egregious lifestyles at the expene of everyone else.

THAT is what must be reversed, no matter what it takes, for the sake of this nation and the American people.

And, no, I do not include the wealthy class as being part of the American people any longer.

They must be made to pay for what they have done to this country.

Posted by Gordon2352 | Report as abusive
 

Retroactive legislation may not unwind any current problems but they’d likely prevent future ones. I’d think an economist with even the vaguest notions of Great Depression reforms to the banking system would know this.

Posted by borisjimbo | Report as abusive
 

Yes and with programmed and HFT trading the market can drop several hundred points and rebound within hours for no apparent reason. This is another argument that relies on the confidence fairies and a set of myths that never seem to play out in the real world.
The fiscal cliff is pretty much imaginary, most of what will happen on January 1 can be addressed with subsequent legislation so the impacts are relatively short term. The markets will likely take into account what negotiations are taking place rather than assuming that the sky is falling.
It is rather ironic to see the folks who brought a real though totally unnecessary crisis to bear with haggling over the debt ceiling, a ridiculous and outmoded idea in itself, now concerned about another so called crisis. I though Mr. Holtz-Eakin was supposed to be a serious economist.

Posted by MJamison | Report as abusive
 

Tea party in the recent past coursed grid lock in some state budgets and in one case I know it lasted for some time. The US tried austerity at first during the great depression.

As long as unemployment is high it is not the time to worry about bond holders. But should try to fix structural problems. Such as failed trade policies (at lest they have not worked for good of the greatest number of Americans). Paying more for education and health care than most nations but getting less results.

Posted by Samrch | Report as abusive
 

Consider the real “cliff” issues. Congress has more than just money problems. Going over the cliff is just an excuse for fiscal policy gridlock. Where is the accountability for our Government’s “police state” foreign policy ? Why are we contributing billions in “foreign” affairs that have NOTHING to do with our “national” health ? So now the president wants to make the rich “pay” their “fair” share ? The rich will do what they always do. Divest in legitimate opportunities and invest in the unfortunate business’s that crash due to this temporary fiscal cliff reform. Financial investment has long been the framework for Americas economic growth. “The cliff” will just move Investors to invest their money from legitimate ROI investing to short term cliff losers who are good for the quick buck to make up the additional taxes that will be levied on their already “meager” portfolios. This does not motivate legitimate investment growth in our economy. It sounds like America is for sale, again, at the peoples’ expense.

Posted by megan759 | Report as abusive
 

@Samrch: Seconded — your comment is worth further consideration.

@Gordon2352: We’re more likely to persuade the wealthy (or, those wealthy people who are not yet persuaded, though many of them have been); if we start speaking about the 100%, rather than attempting to force their hand with divisive politics with talk of the 99% or whatever.

Posted by matthewslyman | Report as abusive
 

Holtz-Eakin comparison of the so called “fiscal cliff” to the passage of TARP in 2008 is a clear example of the hysteria the far right is creating in order to bully through another two years of tax breaks for the super rich.

Most tax discussions only center around W-2 forms of income (where you get paid for actually working 8 to 10 hours a day). Any the highest tax bracket on W-2 income stops at $380K which throws a 2 income family often in the same tax bracket is a chief executive making $10s of millions. Plus W-2 income pays Social Security tax, Medicare Tax, etc. (though there is the $100K limit on Social Security wages – again a big break for upper, upper income).

What is missing in these discussions is the immensely low tax rate on unearned income: capital gains, dividends, real estate 1038 exchanges, oil/gas partnerships and other K-1 and 1099 forms of income. Much of K-1 dividends paid out are not taxed at all because they are considered under our archaic tax code a “return of capital”. 15% tax rate on long term gains is only marginally lower than the 28% top rate on short term capital gains (investment held under one year – often just for a couple of hours). These 1099, 1098, K-1 incomes don’t pay into social security or medicare and can offset these gain in myriad of ways to reduce even the 15% tax rate. This is where the super rich are reaping such a huge % of the nation’s wealth and income. And the low, low rate on short term gains has been a huge benefit to speculators that has led to the boom/bust markets we have today.

Going back to the pre-Bush tax code is a step in the right direction, and having an automatic cut of $50billion in the Defense budget is certainly a HUGE step in curtailing that big waste of money.

Obama and the Democrats should nut feel bullied and rushed into a tax compromise with the Norquist puppets in the House and Senate. It will take months and months of hard work to come up with a new tax structure that actually makes sense. From higher rates on 7-digit W-2 income, elimination of salary caps on social security, cap on low 15% dividend income (maybe 15% on just the first $50K then to marginal income tax rate), and finally 50% to 80% tax rates on short term capital gains. We need to eliminate all preferential rates to real estate, oil & gas structures, off-shore income, etc.

And let’s take $50billion in the Defense Budget and pay off some of our debt.

Posted by Acetracy | Report as abusive
 

Holtz-Eakin comparison of the so called “fiscal cliff” to the passage of TARP in 2008 is a clear example of the hysteria the far right is creating in order to bully through another two years of tax breaks for the super rich.

Most tax discussions only center around W-2 forms of income (where you get paid for actually working 8 to 10 hours a day). Any the highest tax bracket on W-2 income stops at $380K which throws a 2 income family often in the same tax bracket is a chief executive making $10s of millions. Plus W-2 income pays Social Security tax, Medicare Tax, etc. (though there is the $100K limit on Social Security wages – again a big break for upper, upper income).

What is missing in these discussions is the immensely low tax rate on unearned income: capital gains, dividends, real estate 1038 exchanges, oil/gas partnerships and other K-1 and 1099 forms of income. Much of K-1 dividends paid out are not taxed at all because they are considered under our archaic tax code a “return of capital”. 15% tax rate on long term gains is only marginally lower than the 28% top rate on short term capital gains (investment held under one year – often just for a couple of hours). These 1099, 1098, K-1 incomes don’t pay into social security or medicare and can offset these gain in myriad of ways to reduce even the 15% tax rate. This is where the super rich are reaping such a huge % of the nation’s wealth and income. And the low, low rate on short term gains has been a huge benefit to speculators that has led to the boom/bust markets we have today.

Going back to the pre-Bush tax code is a step in the right direction, and having an automatic cut of $50billion in the Defense budget is certainly a HUGE step in curtailing that big waste of money.

Obama and the Democrats should nut feel bullied and rushed into a tax compromise with the Norquist puppets in the House and Senate. It will take months and months of hard work to come up with a new tax structure that actually makes sense. From higher rates on 7-digit W-2 income, elimination of salary caps on social security, cap on low 15% dividend income (maybe 15% on just the first $50K then to marginal income tax rate), and finally 50% to 80% tax rates on short term capital gains. We need to eliminate all preferential rates to real estate, oil & gas structures, off-shore income, etc.

And let’s take $50billion in the Defense Budget and pay off some of our debt.

Posted by Acetracy | Report as abusive
 

Add a federal consumption tax (sales tax) for all goods and services except groceries, medicine, healthcare, and education. Then its governments job to spend within its means (yearly revenue)

In no terms should a deal be struck that continues to speed more than revenue can support. 17 trillion is enough debt. According to us census our national debt is higher than the value of all the land of the combined 50 states.

Posted by bjbouch | Report as abusive
 

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