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Understanding ‘The Cliff’


I was gratified the other morning to hear a long report on NPR’s Morning Edition pointing out what we have been saying here at Beacon Economics for some time—that the fiscal “cliff” isn’t any such thing.

While it is true that Federal spending and tax rates are going to be dramatically affected if a budget compromise is not reached by January 1st, the lack of a compromise will not push the U.S. economy over a cliff and into a recession on January 2nd. Indeed, it will take months, not weeks as NPR incorrectly suggested, for the economy to be pushed into a downturn. This implies that there is time to negotiate some reasonable compromise even after the New Year begins.

We might even presume that there is some functional recognition of this on Capital Hill, and that this recognition explains the relatively lackadaisical pace of negotiating.

The reason for the slow impact is both strategic and because of the way an economy basically functions. Strategically, the President could order Federal spending to continue at a normal pace for a while—with the presumption that the funds would be restored in part once a compromise is reached. Equivalently workers and employers are unlikely to respond sharply to increases in their tax rates due to the presumption that a compromise will be reached and tax rates will go back down again.

And economically, it simply takes a while for a shock to move into the system to the point where it creates this vicious cycle effect: decreased aggregate demand, which causes layoffs, which in turn creates more declines in aggregate demand. Depending on how this plays out, it is easy to imagine that we might not see negative growth numbers until late in the 2nd quarter if not the 3rd quarter.

This misunderstanding is only one of many wrapped around the so-called fiscal cliff. Let me try and clear up a couple of others.

One bit of confusion is natural—the fact that on one hand many economists (including myself) dismiss the argument that higher taxes and a larger government are necessarily bad for growth, while at the same time almost all economists (including myself) agree that the United States will be pushed back into recession (although not until later in 2013) if some compromise is not reached regarding the Federal budget. It is understandable to think that this sounds oxymoronic.

The key is that it’s not the level of taxes and government spending that is an issue for the economy and growth, but the change in the level of taxes and government spending.

The limited relationship between tax rates, government spending, and growth is a long-run conclusion. The U.S. economy currently seems to have the capacity to grow at roughly 3% per year in terms of real output—based on the pace of population, workforce growth, and growth in the capital stock. If tax rates and public spending were higher or lower than they currently are, it would do little to the long-term growth patterns—at least within the range we have seen in the economy over the past 50 years.

Changes in the level of taxation and government spending, however, do seem to have an impact on economic growth for better or for worse—depending on the direction they go. When we cut taxes there is a short-term burst of growth as consumers use their newfound disposable income to purchase goods and services. Equivalently when tax rates are raised, there is a negative shock to the system as consumption drops to a new level. The same can be said for government spending—increase it quickly and it stimulates the economy, reduce it rapidly and the economy suffers an austerity hit—similar to what Greece and Spain are experiencing.

In either case once the economy settles in around the new flow of income and spending, it goes back to its normal pace of long-run growth.

Moreover, the impact on the economy of such short-term disruptions is based mainly of the speed of the adjustment. An economy is like a piece of plastic—bend it slowly and it will take whatever form you like. Bend it fast and it will snap. This is because an economy is an organic system that takes time to adjust to new external situations.

Take for example a budget neutral situation where taxes are raised sharply even as government spending increases sharply. Consumers may spend less on shirts and shoes while the government spends more on guns and roads. It takes time and money for the resources of production to move from one sector of the economy to another—and this temporary disruption has negative impacts for the broader economy—even if the overall level of aggregate demand stays the same.

From this perspective the ideal government policy in business cycles is to rapidly cut taxes and increase spending at the start of the downturn (i.e. deficit spending). The rapid nature of the adjustment creates a positive secondary impact on the economy because of the quick change—and this helps offset some of the negative impacts of whatever is driving the recession in the first place. Then after the recession is over, the policy should be unwound slowly to avoid the negative secondary effects of such rapid adjustments.

{NOTE: The sharp eyed reader may be asking—doesn’t that rapid increase in government deficit borrowing have a negative impact on the economy that offsets the positive increase of government and consumer spending? Great question! The answer is no, largely because such actions typically occur at the start of a recession when there is a big decline in demand for liquid capital—in short the government is mopping up excess liquidity.}

Presumably, if managed right, a reasonable budget policy can smooth the business cycle somewhat by the strategic use of the asymmetry between rapid and slow adjustments in government deficits. Still, many economists (including myself) are largely skeptical of such policies—not because they couldn’t work, but because we are assuming a high degree of reasonableness on the part of our policymakers.

Sadly such rational behavior is too often lacking in the dirty business of a democracy. For example, such policies can only truly be a short-run fix—trying to use this boost all the time would ultimately lead to an unsustainable level of debt and a public debt crisis—hence Southern Europe. Equivalently, we have ratchet effects—where consumers and governments are unwilling to unwind what are supposed to be short-term policies—after all people like lower taxes, higher spending, and more government benefits.

The fact that we create budgets on an annual basis whereas fiscal policies take years to create and unwind only intensifies the situation. And of course our collective ability to ignore a growing mountain of debt (or to assume someone else should pay for it) is truly astonishing.

This of course brings us back to the danger of the so-called fiscal cliff. Although more of a hill than a cliff, we should still have all realized that eventually the day would come when taxes would have to go back up and government spending would have to go back down. This was a natural cost of the value of the deficit spending that occurred in the midst of the Great Recession, and that helped to somewhat reduce the negative impact on the economy. But instead our gridlocked political system has created a situation where no one seems willing to engage in the compromises needed to unwind the deficit spending—leading to automatic and rapid increases in taxes and the reduction in spending on January 1st.

The reason the fiscal cliff could be so dangerous is the speed of the adjustment. If instead of the $600 billion adjustment occurring in one quarter it was instead spaced over a longer period of time (say two years) the negative impact would be considerably smaller—indeed, we might barely be able to detect it in the growth numbers. The slower adjustment lets the economy adjust in real time to changes in economic flows—avoiding the negative secondary impacts caused by rapid dislocation

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