Here’s the path around the fiscal cliff
The “fiscal cliff” talks offer a chance to rebalance the American economy so that the long years of living beyond our means — spending too much and raising too little, paid for by borrowing from the Chinese – will be brought to an end in an orderly fashion. As we have seen from the pitched battle between the White House and the Republican House leadership, finding the right balance between tax increases and spending cuts is not easy.
The guiding principle for both sides, however, should be primum nil nocere: First, do no harm. Having survived the worst financial crash in 80 years, the United States should do nothing to put the fragile recovery at risk. Since the turmoil of 2008, economic growth remains positive but feeble, which is more than you can say for comparable economies, such as the eurozone and Britain, that have battened down the hatches and nosedived into slump. The 17 eurozone countries are deep in recession with joblessness at more than 11 per cent; last quarter the U.K. briefly emerged from a double-dip recession of its own making but is expected to enter a triple-dip recession by the end of the year.
If we get the fiscal cliff bargain wrong–too-large tax increases combined with too-deep, too-early cuts in public spending–we risk tipping the economy back into the painful recession we have just escaped. In Washington, the trade-ff between tax and spending is portrayed as a quid pro quo, with Democrats demanding tax cuts for everyone except high earners and Republicans pressing for deep cuts in Medicare but not defense. The politicians have badly framed the argument. Think of tax and spending — if you will excuse the battered simile — as the knobs on an Etch-A-Sketch. To draw a perfect circle entails turning both knobs together at exactly the right rate.
What if we fall over the fiscal cliff? Under the terms of the sequestration patch concocted last year, come Jan 1, if no deal is reached, $607 billion in tax increases and spending cuts will take effect, draining 4 percent of GDP with no tangible benefit. That would be a disaster. If tax cuts are not extended, demand in the economy will slump, businesses will falter or go bust, workers will be laid off, public spending on the unemployed and their families will increase, public borrowing will rise, and there will be a swift return to recession. Similarly, if public-sector spending is reduced too rapidly, demand will be sharply reduced, thousands of public service workers will be fired and paid unemployment benefits, public borrowing will rise and the economy will tip into recession. As Britain’s self-defeating austerity experiment is demonstrating, government-imposed misery in the name of paying off public debt can lead to increased public debt.
So, what is the way out? The trick is to boost the economy through tax breaks while making a start on addressing our long-term debt problems without cutting so soon and so deeply that the economy stalls. Think of a car with a manual gearbox starting on a hill. By gently pressing on the gas while easing in the clutch, the car smoothly climbs. A little too much on the gas or an abrupt use of the clutch and the car makes a series of unpredictable jolts and lurches that ends in the engine straining, spluttering, then stopping dead.
Cutting taxes when the economy is in the doldrums makes good sense. The lack of government revenue can be made up later, when the economy is booming. The overheated political debate about public debt has been emotional rather than rational, with great-grandchildren yet unborn invoked as helpless victims of a federal government Ponzi scheme, but there is no need to pay down debt immediately if doing so will slow economic growth. That does not mean a plan should not be put in place so we can start paying off debt at a quick pace as soon as growth is strong and everyone is back to work.
As soon as Americans are fully employed again, it will be relatively painless — not pain-free, but not crucifying — to nudge taxation up and steadily pay down the nation’s debt while continuing to reduce spending. This is how the vast debt incurred by Ronald Reagan was paid down in the Clinton years. What makes immediate, deep debt reduction so unfair is that those in work must pay off the debt without the help of the 8 per cent plus who are unemployed and paying no tax.
Ideally, debt reduction and federal taxation changes would be pegged either to the growth rate – the faster the economy grows, the more money can be taken out of the economy without risking recession – or tied to the unemployment rate – the more who are paying tax, the quicker the debt will be reduced – or both. A sensible course would be for the payroll and income tax breaks to resume on January 1 alongside a rigid timetable for paying off debt in the years ahead. Instead of the timetable having dates, however, the debt repayments and the increase in taxes would be triggered by the rise in growth and employment figures. It would be a rules based formula that is both economically apt and politically attractive.
Would it have made any difference to the fiscal cliff debate if we had elected Mitt Romney? A year ago, Romney said, “If you take a trillion dollars, for instance, out of the first year of the federal budget, that would shrink GDP over 5 percent. That is by definition throwing us into recession or depression. So I’m not going to do that, of course. I don’t want to have us go into a recession in order to balance the budget.” He was talking sense. But was his party listening? Apparently not.
The question now is whether the GOP House leadership is prepared to accept the blame for insisting we pay off public debt too quickly, returning America to recession, or whether it is prepared to lead the nation in a lemming-like leap off the fiscal cliff, which will also result in recession. It is not a pretty choice. Tying tax levels and debt reduction to growth and employment would let the Republican leaders — and the White House — off the hook.
Nicholas Wapshott’s Keynes Hayek: The Clash That Defined Modern Economics is published by W.W. Norton. Read extracts here.
PHOTO: Construction workers walk over the Titlis Cliff Walk suspension bridge in front of the peak of Mount Titlis (3,238 m/10,623 ft) near the Swiss mountain resort of Engelberg December 1, 2012. REUTERS/Arnd Wiegmann