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.

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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.

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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.