DRI-241 for week of 12-2-12: Look for the Fiscal Cliff in the Rear-View Mirror

An Access Advertising EconBrief:

Look for the Fiscal Cliff in the Rear-View Mirror

With the demise of responsible journalism has come the advent of the “hook,” an attention-grabbing theme or event that acts as a long-handled tool with which to snag the media consumer. These days, the hook du jour is the so-called “fiscal cliff,” an economic precipice off which our figurative fall is scheduled for January, 2013.

As popularly defined, the fiscal cliff is a media-bred and -fed red herring that serves to distract attention from our real impending calamities, which are much worse than those imagined by the press.

The “Fiscal Cliff” as Conventionally Viewed

The conventional explanation of the fiscal cliff goes as follows: Beginning in the New Year, various cuts in federal-government spending and increases in federal taxes are scheduled to occur. The cumulative impact of these actions will be sudden, large and adverse. Hence the metaphor of a cliff, whose “fiscal” dimension refers to the government-expenditure-and-taxation connotation of fiscal policy.

In order to swallow this conventional view, we must believe it to be correct. That involves more than its factual accuracy; it also refers to its inherent soundness.

The fiscal-cliff narrative implies that both decreases and government spending and increases in federal tax rates are “bad for the economy” in some clear-cut, obvious way. The usual presumption is that they are both contractionary, tending to induce recession. The problem is that there is no reason to believe this.

Why the Conventional Thinking About the Fiscal Cliff is Wrong

The planted axioms in fiscal-cliffery are deep-rooted in contemporary life. They are have been repeated so long by the news media that the citizenry accepts them as gospel. They are fundamental principles of Keynesian economics. In the simple Keynesian economic model, the multiplier principle assumes that autonomous expenditures by government create multiple increases in income and employment. (It should be, but seldom is, put it more carefully: Whenever the economy operates at less-than-full employment, this multiplier effect will hold true.) It is trundled out and paraded by local news outlets every time a convention hits town or a sport team wants a justification for public subsidies.

If this proposition were true, we need never fear the onset of recession. Simply crank up the government spending mechanism and restore prosperity and full employment. It should be plain to one and all that it is false. History refutes it. In line with Keynesian precepts, government spending steadily increased throughout the 20th century and into the 21st, both in absolute terms and relative to tax receipts and aggregate income. Contrary to received wisdom, recessions were not banished by this spending regimen.

There have been no recorded instances of recessions-in-progress halted and reversed by timely administrations of government deficit spending. There was a brief period in the early 1960s that was hailed as the dawn of a new Keynesian age, but it began years after the Eisenhower recession and was stopped in its tracks by a combination of recession and inflation in the late 1960s. The phenomenon of stagflation continued into the 1970s throughout the Western industrialized nations, confounding Keynesian theorists and leading politicians like Great Britain’s James Callaghan to publicly repudiate Keynesian orthodoxy.

Both the Thatcher administration in Great Britain and the Reagan administration in the U.S. accepted recession as the price for ending double-digit inflation. They were rewarded by the subsequent long climate of prosperity known as the Great Moderation, which lasted into the next millennium.

The empirical defeat of Keynesian economics was mirrored by its theoretical decline. This took place over a longer time frame but was equally decisive. It is doubtful if any theory in the physical or social sciences was ever subjected to scrutiny so long-lasting and thorough. Over some 45 years, the economics profession obsessively focused on little else. By the early 1980s, the verdict was in.

Keynes had made his case in favor of government deficit spending on three grounds. Non-professional students and a few economists had long nourished a grudge against free markets on account of their alleged underconsumption. Increases in productivity and investment, it was alleged, would lead people to spend too little of their income, causing unsold goods to pile up and recessionary layoffs to ensue. Although Keynes did not incorporate this notion into his theory, he expressed sympathy for it. A decade before Keynes published his General Theory in 1936, two American economists named Foster and Catchings anticipated him by calling for a program of government spending to take up the slack created by private oversaving and underconsumption. In his 1931 article, “The Paradox of Saving,” F.A. Hayek meticulously explained why Foster and Catchings were wrong.

Keynes identified various flaws in the operation of free markets that he hauled out to justify activist government policies. These flaws formed the basis for the neo-Keynesian theory developed by his disciples after Keynes’ death in 1946. One by one over a 45-year period of controversy and research, each one was refuted. Keynes developed a theory of consumption as a simple linear function of income, used to buttress his concept of the multiplier. This was overturned by research done by three later economists, two of them Keynesians. Keynes insisted that downward inflexibility of wages and prices would prevent restoration of full employment without government intervention. History and research have also overturned the empirical basis for this strand of Keynesian thought. Falling prices, or deflation, would cause real incomes to rise through the operation of the real-balances effect. In other words, there is no inherent tendency for a fall in aggregate demand to result in unemployment of indefinite duration.

In later sections of the General Theory, Keynes gave his anti-capitalist prejudices free rein and inveighed against what he called “the fetish of liquidity;” e.g., the desire to hold money as a hedge against uncertainty. Keynes claimed that central banks should increase the money supply sufficiently to drive interest rates to zero (!), so as to discourage the demand for liquidity and end the scarcity of capital. The Great Recession of the New Millennium has given policymakers the chance to put this notion into practice. The technique of quantitative expansion of the money supply has kept interest rates artificially low in Japan for most of two decades; in the U.S., for about three years.

Japan’s economy has become nearly dormant, while the U.S. has seen a torpid recovery gradually metamorphose into a double-dip recession. So much for “the fetish of liquidity”! Near-zero interest rates did not end the scarcity of capital – quite the contrary; they made it nearly impossible to judge the relative usefulness of different capital assets and ushered in a state of near-paralysis. These recent examples reinforce the earlier experience of the Soviet Union, where the absence of market interest rates made it impossible for Soviet planners to judge the relative efficiency of different investments.

Finally, those without a sense of history or a nose for theory can simply review the results of the huge stimulus bill passed in early 2009. Government action was supposed to be better than waiting interminably for private markets to restore full employment. Instead, we waited interminably for government to spend stimulus money and then…overall employment continued to fall. Most of the glacial reductions in the rate of unemployment were due to dramatic declines in the rate of labor-force participation. Nobody can credibly maintain that Keynesian economics lived up to its billing.

Fiscal Cliff – or Fiscal Standoff?

We should not recoil in horror from reductions in government spending. When the federal government declines to spend our money, this does not constitute a lost opportunity to conjure goods and services out of thin air. It simply means that resources that would otherwise have been used to produce goods at the direction of government are now free for alternative use. This is no tragedy. Since the private sector follows the guideposts of profit, consumer sovereignty and utility maximization, the resources will probably be put to better use there than in the public sector anyway.

Nothing has been said here about where the spending reductions would take place. In principle, that should matter. After all, there are a few valid examples of public goods – goods that cannot be privately produced because private producers could not exclude non-payers from consumption and which cannot be consumed by one without being available to all. But the fiscal-cliff melodrama now playing full-time in media outlets makes no distinctions of this kind. It treats all government spending reductions equally, implicitly following the dictum of the late Keynesian economist James Tobin, who proclaimed, “Spending is spending; it doesn’t matter what you spend the money on.”

If government spending cuts are a bogeyman, who is it lurking underneath the white sheet blurting, “Boo!” Perhaps the defense of simple ignorance can absolve the news media for misinforming its audience – or perhaps not – but why don’t the President, Congress and professional economists blow the whistle on this farce? Each benefits from lying to the public about government spending, both in general and in this particular instance.

President Obama gains because his entire professional existence is focused on maximizing the power, influence and activity of the federal government The Republicans made the strategic mistake of assuming that the ineffectiveness of President’s policies would doom his candidacy. As this space accurately predicted three years ago, the President’s policies were not intended to be effective in the traditional sense, although that outcome would have been a welcome byproduct had it occurred. The policies were intended to make as many people as possible either employed by, subsidized by or beholden to the federal government. Thus, policies that increased unemployment rather than reducing it were still successful if they increased participation in unemployment benefits, food stamps, administration of benefits or any other government-related activity.

Democrats gain in Congress because their strategy is focused on demonizing Republicans. Their constituency consists overwhelmingly of net beneficiaries from redistributing government spending – or people who consider themselves net beneficiaries. By painting government spending as ipso facto beneficial, Democrats can achieve what gamblers call a “middle” – they can win either way. If Republicans cave in and restore threatened spending, Democrat constituents and their patrons in Congress gain. If Republicans hold firm against negating the cuts, Democrats can paint Republicans as villains. What’s more, if the overall economy deteriorates markedly as seems increasingly likely, Republicans will bear the blame for forcing us off the fiscal cliff.

Difficult as it may be to believe, Republicans also perceive gains from perpetuating the myth of the fiscal cliff. For one thing, Republicans have their own roster of constituent beneficiaries from federal-government subsidies, so they are secretly content to see spending continue – at least spending that they approve of. For another, Republicans also harbor hopes of blaming Democrats for anything that goes wrong next year. Most tellingly, Republicans by now have acquired a pathological fear of being publicly blamed and stigmatized by Democrats for anything and everything. They visualize an outcome similar to past misadventures with the debt ceiling and other attempts at spending discipline. Like whipped dogs, they cower in fear of another beating and will crawl in submission rather than face one. Thus, they are afraid not to cut a deal avoiding the mythical fiscal cliff.

One other factor influences Republican fear; namely, the other face of the fiscal cliff – tax increases.

Tax Increases – Good or Bad?

Republicans, goaded by longtime anti-tax activist Grover Norquist, have built a solid reputation as the party of opposition to tax increases. It is just about their one remaining principle of any substance. It dates back to the days of supply-side economics and the presidency of Ronald Reagan, whom Republicans venerate as the Democrats traditionally do Franklin Roosevelt. Is this principle well-founded?

The answer is complicated. Economic activity is conducted at the margin, so increases in marginal tax rates are well worth opposing because they deter the activities being taxed. Since most taxes are on earned income or production of goods and services, this means that taxation has an adverse effect on economic activity. This idea is conveyed by economic specialists in public finance through the concept of the “excess burden” imposed by the tax. On the other hand, surtaxes and lump-sum taxes have comparatively little effect on economic activity one way or the other – not enough to drive an economy off a cliff.

Many Republicans would really prefer to separate the issues of spending reductions and tax increases by embracing the first and opposing the second. But their track record on making fine distinctions in public debate is so dismal that they are inclined to give up that project as a bad job. After all, they had a whole year to work with but couldn’t even convince a majority of the electorate that Barack Obama was a bad President. Teaching the public basic economics in less than one month seems like a lost cause.

If the distinction between spending decreases and tax increases seems arcane, the bottom line about tax increases will sound positively esoteric. The Keynesian view of taxes is the same as that of spending – taxes are taxes. They affect the economy only as the receipt or loss of income rather than through their effect on incentives and behavior. Thus, their impact is cyclical; tax changes increase or decrease the likelihood of recession or expansion. But in reality, the Keynesian view is wrong here, as elsewhere. Changes in marginal tax rates affect long-run growth. (Whether the effects are temporary or permanent is another complex question.) They have little or no effect on business cycles because the causes (and cures) for business cycles lie elsewhere than with changes in aggregate demand. This is still one more reason why the current debate over the fiscal cliff is phony.

There is true irony in the fact that we are confronted with this faux fiscal cliff that nobody is willing to expose. We are facing a very real fiscal cliff. Or rather, we faced it over a period of decades. But we drove off the cliff like Thelma and Louise. Now the cliff is fading into the distance above us, getting small in our rear-view mirror. And we are about to crash into the ground below.

The Real Fiscal Cliff

The real fiscal cliff is the debt and spending behavior of U.S. governments at every level. The federal government’s debt (public and inter-governmental) is now approximately the size (100%) of annual GDP, or roughly $16 trillion. But this does not begin to capture the true size of federal government obligations. Taking future Social Security and Medicare committments into account (on a discounted present value basis) would make that number over 4 times greater. The Federal Reserve is monetizing debt; e.g., indirectly paying for government expenditures by creating money used by banks to purchase government bonds. This is a traditional sign of a government in the throes of a debt crisis, about to succumb to hyperinflation.

The Fed has created vast sums of money, but so far this has contributed only modestly to measured inflation because most of it has sat idle in excess bank reserves. By changing the rules allowing it to pay interest on those reserves – and by tightening regulations on conventional business loans to draconian degree – the Fed has persuaded banks to forego traditional lending and fatten their income statements passively. Meanwhile, the Fed has desperately tried to pump up real-estate prices and mortgages by buying mortgage-backed securities, the toxic asset most prevalent on bank balance sheets. In other words, the Fed has put the real economy in a therapeutic coma – therapeutic for banks but not for everybody else.

The Fed is working against time because default dominoes are wobbling in Europe. Greece has already defaulted; Spain, Italy and Portugal are on the brink and France is starting to look shaky. Outside Europe, Japan’s debt makes the U.S. look conservative by comparison and its coma is now Rip Van Winkle-length. This worries the Fed because U.S. banks are owed money and/or financial assets by banks in these countries, where the banking systems are mostly in even worse shape than ours.

Just about the only virtue displayed by leaders of the European Union is that they see the handwriting on the wall, even if they show varying degrees of willingness to act on their knowledge. But as an editorialist at London’s Financial Times recently observed, the belated willingness of Europe’s leaders to address the crackup of socialism and the welfare state comes just as the general public in the U.S. is embracing socialism at the polls.

In the past, economists have allayed fears about federal-government budget deficits by contending that what matters is the unified budget of state, local and federal governments. For many years, state government budgets were constrained by statute and tradition to remain in balance or even in surplus, thus offsetting federal extravagance somewhat. But today, at least a dozen state governments are nearly as bad off as the federal government. These include some of our most populous states, such as California, Illinois, New York and New Jersey.

The rot extends down to the level of city government. Detroit, Michigan was once an American powerhouse, home to the Big Three automakers. Today it lays in ruins, a dysfunctional ghost town whose City Council is reduced to begging for bailouts from a federal government that cannot bail itself out. Stockton, California has declared bankruptcy; a few other cities are teetering on the edge. Some major cities, like New York City and Chicago, are out of control and in decline.

If the American public and policymakers were united in perception and purpose, heading off default would be difficult. It would require a reversal of economic policy to promote economic growth. First, though, markets would have to reset and housing prices in numerous markets throughout the country would have to be turned loose to find their own level. This would entail a recession of indeterminate length, unfortunate but just as unavoidable as was the short, sharp recession back in 1981-82. Then government spending would have to be massively reduced – not trimmed, but chopped with a meat ax. Whole Cabinet-level departments would have to be eliminated and their work forces terminated.

Instead, we are traveling in exactly the opposite direction. Vice-Presidential Ryan’s modest proposal for entitlement reform went down to defeat along with Presidential candidate Romney. The two parties are squabbling about trivial differences in a plan for avoiding a fiscal cliff that doesn’t exist.

Après Moi, Le Deluge

Legend has it that his ministers confronted France’s Louis XV about the profligacy of his spending – palaces at Vincennes and Tuileries, wars against European rivals, a stable of mistresses including Madame de Pompadour. What legacy would he leave his successor and the nation? The king shrugged. “Après moi, le deluge,” he replied. (“After me, the deluge.”) That is apparently the position taken by politicians in Washington, D.C. in the face of the greatest crisis the United States of America have ever faced.