Why the Fiscal Cliff is the Wrong Thing to Worry About

The resolution of the Fiscal Cliff will probably no solve much, while little attention is paid to the real economic problems.

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J. Scott Applewhite / AP

When asked what it was like living through the German bombing of Crete during World War II, British novelist Evelyn Waugh replied that it began impressively enough but went on far too long. The same might be said for the current debate over the Fiscal Cliff. This issue loomed large during the Presidential campaign, but now promises to become an endless and tedious dispute. In the end there will probably be an unsatisfying compromise that avoids disaster but solves nothing important, while little attention is paid to America’s fundamental economic problems.

The essence of the debate is that the Federal government has been running an ultimately unsustainable deficit of more than $1 trillion a year. A variety of changes in taxes and government spending are scheduled to go into effect in 2013 that would reduce this deficit by as much as $645 billion. That would bring the deficit down to a tolerable level, but poses two problems. First, more than two-thirds of the financial burden of this reduction would fall on the middle class – something both political parties have promised they would avoid. Second, there is genuine disagreement as to whether such a sudden drop in the deficit would be a drag on a still-weak economy.

(MORE: As Fiscal Cliff Approaches, Mayors Warn of the Toll on Cities)

One school of thought is that there is plenty of money around, thanks to the Federal Reserve’s policy of quantitative easing. In addition, U.S. corporations have accumulated a cash hoard of more than $1.7 trillion, according to the Fed, and may have trillions more stashed in overseas subsidiaries. The reason for today’s slow growth, therefore, is not a lack of money but rather the fact that everyone is hesitant to spend because of uncertainty about the deficit, taxes and government policy generally. From this perspective, any consensus solution that starts bringing down the deficit would unleash loads of consumer spending and business investment.

The alternative viewpoint, advocated by economists such as New York Times columnist Paul Krugman, is that reducing the deficit makes no sense at all in present circumstances. As long as the economy is limping, inflation is not a risk. And spending that revs up growth will do more to improve the long-term financial health of the U.S. than reducing the current deficit will.

The specific details of a solution to the Fiscal Cliff may be uncertain, but the basic outlines seem fairly clear. First, the government will not allow a default or some other financial catastrophe to occur. Second, the cliff isn’t really a cliff but a slope. The problems will slowly intensify over the coming year and can be fixed at any point – or even in stages. No one wants the full spectrum of tax increases. Spending cuts that are truly intolerable will be reversed. Some progress on deficit reduction needs to be visible. What will be the overall effect on the economy of all these compromises? Probably not much.

(MORE: Fiscal Cliff Leaves Non-Profits On Edge)

There is, however, a real debate that is not occurring but should be. While it is true that a large deficit in any particular year is not a problem, longer term trends do matter. If national debt is relatively low – less than 50% of annual GDP, say – there’s plenty of room to spend in the short run and then balance the budget later. This is basically what happened over the course of the combined Reagan and Clinton administrations. The result was an economic boom that lasted more than 20 years.

But as debt rises beyond that level, a country’s core growth rate begins to slow. Indeed, the National Bureau of Economic Research calculates that when debt passes 90% of GDP, average annual growth slows by one percentage point. Basically government borrowing competes with businesses that want to borrow to invest and raises their interest costs, while interest payments on government debt eat up money that could either go for infrastructure investments or tax cuts.

It’s a bit difficult to gauge exactly how close the U.S. is to the danger zone, because debt held by the Social Security Trust Fund doesn’t really count (it’s money the government owes to itself). However, at the current rate, the U.S. will probably start feeling ill effects within four years or so. Any reduction in the deficit that comes about because of fiscal cliff negotiations will only be large enough to push the deadline back by another two or three years.

A one-percentage point reduction in the annual growth rate of the U.S. economy may not sound like a big deal. But after 15 years it would mean that the standard of living would be almost 15% lower than it would otherwise be. Unemployment would be higher and incomes would probably be more unequal. And finally, the ability of the U.S. to run future deficits would be greatly reduced. For debt to remain constant as a percent of GDP it can only grow as fast as the economy. Today’s $1.6 trillion economy can support a $520 billion deficit if growth is 3.25% (the historical average for the U.S.), but only $360 billion if growth is 2.25%. What that means is that if debt continues to climb, the U.S. will need additional tax increases or spending cuts equivalent to $160 billion today – or roughly twice the amount of money that would come from raising income tax rates for the rich.

(MORE: Wall Street’s Bet on the Fiscal Cliff)

Whatever resolution is achieved for the Fiscal Cliff will probably make very little difference to the long-term trajectory of the U.S. economy. What does matter desperately is entitlement reform, controlling the growth of health-care costs and, ideally, some sort of comprehensive tax reform that could raise a bit more money while being less of a burden on economic growth. Unless these issues are addressed, the Fiscal Cliff debate may monopolize the attention of legislators and commentators, but it will all be a lot of sound and fury signifying very little indeed.

27 comments
MarkPashCfp
MarkPashCfp

The Great Recession was NOT caused by the tax & spend fiscal system.  Therefore the solution is not there but in the monetary-financial system.  The commercial banking system collapsed causing the government's tax revenues to go down and the safety net expenses to go up.  In Europe they also had to bail out their banks.  The money created by the Federal Reserve is sitting as reserves in the Central and Commercial banks along with the insurance companies and Sovereign wealth funds.  It is not in circulation!   Deficit spending is a way of offsetting this lack of money needed for commerce.  Is it to early to stop?  Has the commercial banks started to lend enough?  I don't think so. 

The answer is the monetary system needs complete reform.  We are not even debating it.  The answers are at www.monetary.org and www.cpe.us.com.  Start your research!

Center for Progressive Economics

zhuyong127
zhuyong127

i think china also have this thing,but china’s ecnomic keep growth through the investment and deficit. 

tpaine
tpaine

In short, we have a spending problem not a revenue problem.  EVERY federal program should be looked at with the qualifier:  "Is this program worth borrowing 40 cents of every dollar spent from the Bank of China?"

There's a reason the richest nine counties in the U.S. are centered around Washington D.C.  I favor moving our nation's capital to Omaha, NB.

hunterp289
hunterp289

If the Bush Tax Cuts are the source of all problems, why didn't they expire when they were supposed to?  By now, we would be living in a real recovery!

jsrbanjoman
jsrbanjoman

what you and krugman fail to accept and realize is that we don't have a taxing problem.  we have a spending problem.  you basically did not mention the stone cold fact that spending is just way too high.  you never mentioned things like making actual cuts (this means you spend less this year than last year) to ALL entitlement programs.  this means going back to clinton era spending levels.  this means you have to roll back all of the baseline budget increases that were made more or less permanent by the porkulus plan of 2009.  real cuts are the only way you're going to get where you need to go.  and you cannot get that from the military.  sure, you can cut back around the edges militarily, but you can't do it on the backs of the military.  you have to cut food stamps, afdc, welfare, heating programs, ss, medicare, medicaid and all the rest.  it has to go.  government MUST do with less money.  the economy will not be able to sustain the level of spending that liberals see as needed.  its policies are taking us over the cliff and down the slope already.  doing more of the same definitely will not reverse the problem. 

doctorfixit
doctorfixit

"It’s a bit difficult to gauge exactly how close the U.S. is to the danger zone"?

That's because you're the frog sitting in the warm water.   The federal government  is cooked.  Finished.  The so-called "fiscal cliff"  doesn't begin to touch the level of spending that would have to  be cut.  

btt1943
btt1943

Never mind about the fiscal cliff, focus on the national debt.The US national debt now stands at $16.3 trillion. How many people really know what a billion is, let alone a trillion, what more 16.3 trillions?Government keeps printing big money at full force, estimated up to maximum of $8 billion a day. At 24 hours a day, 7 days a week and non-stop, it would take more than 5.5 years to get $16.3 billion printed. During this period, the debt could have soared 80 to 100% higher.End result: Go for default. Can't believe, just wait. (vzc1943)

dochosvet
dochosvet

Finally some says out loud that SS is loaning money to the federal government.  Probably the reason the republicans want to lower SS payouts is so they can borrow more for government spending,

rjsigmund
rjsigmund

"any consensus solution that starts bringing down the deficit would unleash loadsof consumer spending and business investment"

i know a lot of people who arent even buying gifts for christmas because of the deficit...

akpat
akpat

So much of the fed budget is borrowed money it really needs a good solid correction. To balance requires a 50% cut in military spending, a 50% cut in non SS/med 'entitlements' a 100% cut in pork and after that raise taxes on the rich, corporations and imports.

Contrary to republican beliefs there is no correlation between tax rates on the rich and economic strength and in many cases this country has had some of its strongest economies when the tax rates on the wealthy were 50% and above. Its also time to do away with the low capital gains tax and the biggest welfare give out the tax differed roll over.

Sooner or later the piper has to be paid.

dumbledore04
dumbledore04

This is actually pretty simple. Debt is not a big problem. What you borrow money to pay for is the problem as is what you do when the time comes to pay the debt off.

So, during the Depression of the 30s we spent a lot of money nobody had. But we built roads, tunnels, bridges, office buildings, research laboratories, schools, colleges, electrical grids, dams, power generators, irrigation networks etc. 

These investments made us wealthier as a country.

W borrowed much more money than anyone in America ever had and he bought almost nothing with it. Worse still, at precisely the point when we were in a position to pay off old debts, replenish the social security trust funds and store up capital for a rainy day, W declared a party - tax cuts for those who had profited from the prior government debt. 

We do not have a viable choice of not borrowing at the moment. W crashed our economy. We either continue in crash mode - because those sitting on the sidelines aren't willing to invest unless we pay exorbitant blackmail or we borrow and make sure we get something of value for our indebtedness.

But, after we get our economy moving we can't give those who will profit from our new indebtedness an additional handout - we need a tax code that punishes extreme wealth accumulation. Let's say for starters wealth over $  1 Billion that is not invested in job creation and social benefit - just the way we require charitable foundations to spend their money doing good.

tpaine
tpaine

With apologies to Nebraska both for inflicting the nation's politicians on you and whose abreviation is NE not NB.

tpaine
tpaine

There you have it.  Working, middle class Americans, according to Democrats, need to pay an additonal $2,700/yr to support wildly popular spending programs like the ObamaCare Tax and studies on the breeding habits of rats and rabbits.

mkurbo
mkurbo

@jsrbanjoman - Exactly !

How can they even start on spending cuts when they don't have a budget ?    Socialist leaders throughout history would die for a situation where they enforce their agenda without regard to spending controls.

dumbledore04
dumbledore04

at 8 billion per day it takes two days to print 17 billion...

Can any of you do basic math?

mkurbo
mkurbo

The euro is in economic disintegration and there is no real fix for the situation. The EU (eurozone union) has said it will sell bonds backed by all EU members, but this is just more borrowing under a different name to bailout insolvent EU members.The root cause is socialist economic structures which have government and public sector costs that are unsustainable.

Instead of owning up to this fact they have blamed banks, market bubbles, the US economic meltdown – and my favorite – even the bond buyers and creditors which have provided them funds well past common sense.

The debt is very much of their making over a longer period of time then most will admit. America has the same problem now thanks to Obama and liberal policies that have been implemented over the years when the left has controlled of congress.The solution is to cut government and public sector size and spending by 30%-40% and lower all forms of taxes and reduce regulations. This reduces the load which the private sector carries and allows growth and prosperity to occur. How far could you walk/run carrying a load equal to half your body weight ?

There are warnings everywhere in Europe. It’s no longer Ireland, Portugal, Spain, Greece, Italy, Cyprus or Iceland (which is now opposed to joining), but has spread to France and many of the “Nordic” members as well. The first five pages of comments are truly worth review if you want to understand the situation:http://www.telegraph.co.uk/finance/financialcrisis/9610717/French-business-erupts-in-fury-against-disastrous-Francois-Hollande.html

mkurbo
mkurbo

@ViableOp - Washington does not need any more "breathing room" - are you nuts ?  Government spending needs to be cut by 35-40%.  Increasing capital gains is a real bad idea - you will further choke the economic growth engine that is required to pull you out of these mess.  You are repeating old failed leftist ideas...

superlogi
superlogi

@ViableOp And, as you're confiscating money from those who produce wealth, increasing business expenses through taxing and increased regulation and as a consequence, reducing all government revenues, what do you suppose will happen to economic recovery?  The only compromise which will increase economic growth and fiscal sanity is to live within one's means.  That means, to all of you who want things, but aren't willing to pay for them, the gravy train is coming to an end.  Washington doesn't need breathing room, it needs a hard lesson in frugality and efficiency which it is about to learn as do both state and local governments.

tpaine
tpaine

Still waiting for the first Democrat to explain to me how tax increases create jobs.  Care to take a stab at it?

tpaine
tpaine

Why, indeed, have Senate Democrats failed to pass a budget for three years running?

jason024
jason024

@superlogi @ViableOp Same old tired argument. We have GIVEN AWAY money in the Bush Tax Cuts to the "job producers" and they did nothing with it. No Jobs, no investment, etc for 12 years.   The fact is EVERYONE will have to pay. Not just the rich but the middle class as well. Which is why the mortgage dedcution needs to be capped if not eliminated as well as the other tax loopholes that allow people and companies pay at a lower tax rate. 

We can live within our means but we will also as you said need to pay for it through reforming the tax code and raisng taxes on the wealthy back to the Clinton Era levels.

mkurbo
mkurbo

@tpaine - They create more public sector jobs which is now like the WPA for the left.  The public sector and the fictitious "green" sector are the job platforms of choice for the new Obama socialist left.

mkurbo
mkurbo

@jason024 @superlogi @ViableOp 

No, yours is the same old tired (and failed) argument. You could cut the unemployment rate in half over night and grow the economy at 7.5% plus for decades with three easy steps:

> 1) Cut corporate tax to 15% and 7.5% for companies that employ greater than 55% of their workforce in the US.

> 2) 7.5% flat for all under $250k and 17.5% over $250k (only mortgage and charity deductions stay).

> 3) Limit the size of Fed. Gov. to 17.5% of GDP and repeal all federal regulations back to 1990 and freeze new regulations for 25 yrs. (close the EPA as a federal agency).

The economic boom would come quick and remain as long as you followed the formula.

superlogi
superlogi

@jason024 @superlogi @ViableOp You don't have any facts which is why you haven't cited any.  But, here's a fact, that nasty 1% you talk about paid a bigger share of income taxes under the Bush marginal tax scheme than under the Clinton scheme.  Kind of puts you so-called "facts" to rest doesn't it?  By the way, unemployment today is higher than when your buffoon took office and the job participation rate hasn't been this bad for over 30 years.