Here’s the path around the fiscal cliff

By Nicholas Wapshott
December 3, 2012

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

6 comments

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All I read is: “Re-inflate the bubble please!”. America and the rest of the world needs to realise you cannot ‘engineer’ the boom and bust of economies. That is exactly what was attempted in the Clinton years – money was borrowed and pumped into the economy at an unprecedented rate and everyone celebrated their ingenuity as the debt of the Reagon era was apparently repaid, however, the problem is that this debt was paid off with ‘bubble froth’ and not with sustainable economic activity (think main street industries). The real solution is that America needs to get off two practices: firstly, fractional reserving. Banks should be allowed to lend out money they have, not 10 times the money they have. Second, borrowing to fund the government’s budget – if the government wants to spend it must be on a cash basis. Now I understand that this will involve a massive contraction of cash and related unemployment – but America will rebound as it always does (think back to the Great Depression), and when it does it will be solid as a rock and not a house of cards. Alternatively, we can continue delaying the pain and have the financial engineers of government and business continue to rob the rewards of main street and the salary earner. Pick wisely.

Posted by BidnisMan | Report as abusive

This is nothing more than a pathetic attempt by yet another wealthy person to frighten the American people, UNLESS of course we lower taxes on the wealthy class.

In which case, everything will be back to “normal” — supposedly the old trickle down theory of wealth overflowing to the masses to create jobs. Whenever I hear anything that approaches that “philosophy” I think of an overflowing toilet, because that is the only kind of trickle down the rest of us will ever get from the wealthy class — but in this case it is the “norm” that has driven us to the edge of the “fiscal cliff”.

This isn’t about economics — it is about greed by those who have ruined this country in every way imaginable, and now have the unmitigated gaul to want the 99% to pay the bill.

Recucing “social expenses” in the future is ludicrous, since they will grow — due mainly to the baby boomers retiring — not shrink, so your idea of magically reducing public spending is disingenuous.

My solution is a whole lot simpler than yours — PAY YOUR FAIR SHARE OF TAXES and stop whining about it, OR face a forced redistribution of income.

THAT is the real path around the “fiscal cliff” that YOU people created.

Posted by Gordon2352 | Report as abusive

The problem is that the current President is not in favor of Capitalism, and cannot grow the economy. It is not his fault; he was indoctrinated as a youngster with socialist ideas, and he is by nature totally inflexible and unable to change course. If Hilary had been elected in 2008, the economy would have recovered by 2010 at the latest. The same is true of either John McCain. The technical indicators of the end of the recession were in June of 2009. This current President is directly responsible for lack of recovery. But because he is winsome and personable, and because the people believe him, he was re-elected. Socialist ideas don’t work even in Communist countries, much less Capitalist countries.

Without growth there can be no real increase in income, or decrease in spending (as a % of GDP). I see no hope of this before 2017. Even then, there will be 8 years of damage to undo, and a deficit that will most likely be over 20 Trillion dollars.

Posted by stevedebi | Report as abusive

This may be the dumbest analysis I’ve seen yet of the “fiscal cliff,” accompanied by the worst prescription for its cure.

Describing our deficit problem as “spending too much and raising too little, paid for by borrowing from the Chinese” displays a lack of understanding of the role our trade imbalance plays in driving deficit spending. A massive trade deficit drains dollars from the economy, dollars that have to be plowed back into it through deficit spending to avoid a state of permanent recession. The Chinese don’t “lend” us money out of the goodness of their hearts or because we begged them for it. They buy U.S. debt because their trade dollars are worthless if not invested in dollar-denominated securitites.

The belief that cutting federal revenue could somehow offset the negative consequences of our trade deficit and somehow, magically, boost growth is what got us into this mess in the first place. There are no genuine solutions to the “fiscal cliff” that don’t begin with addressing our failed trade policy and restoring a balance of trade.

Pete Murphy
Author, “Five Short Blasts”

Posted by Pete_Murphy | Report as abusive

@Pete_Murphy: That’s right. The Chinese “lend” money to the USA in the same way that I “lent” money to my grandmother when I was ten years old, playing a game of Monopoly with her that I wanted to win with as much money as possible… I kept “lending” her more and more money so that I could get a bigger win in the end! After about six hours, she tired of the game (unsurprisingly). How long will it take for the US government to notice what’s happening, or, to admit to the American people that (as has been stated by UK politicians such as Vince Cable), we are in the “economic equivalent of war”?

Posted by matthewslyman | Report as abusive

@Wapshott: An aside: Every time I read your name, it makes me think of a 17th/18th Century firearm, or makes me visualize a 16th Century type of ammunition for cannon. It sounds old. Where does your name come from? This looks somewhat convincing to me:
http://www.houseofnames.com/wapshott-fam ily-crest

Posted by matthewslyman | Report as abusive