The Coming Fiscal Cliff

It’s one thing when economists like Paul Krugman publicly criticize the austerity measures being employed in Europe and the proposed spending cuts under consideration here in the United States, but when a conservative think tank like the American Enterprise Institute joins in, it’s time to get out that Mayan calendar.

Seems the AEI has figured out what just about everybody with a calculator has known for some time: that the drag on the U.S. economy has been public sector job losses, not private sector job growth.  To prove it, they found some, shall we say, rather interesting statistics.  Over the last eight quarters – two years – public sector GDP has shrunk, while, conversely, for twelve consecutive quarters – three years – private sector GDP has increased.  In the last year alone, according to a Wall Street Journal report, federal spending decreased “more than 3 percent.”

When you subtract the public sector job losses, what you’re left with is a private sector growth rate of 3.3% over the last twelve months, which is about half a point higher than the average private sector growth rate over the last 25 years.  Indeed, were it not for the reduction in government spending, most of which came from cuts to the defense budget and local and state governments, the economy would be doing much better than it currently is.

When the Wall Street Journal and the American Enterprise Institute start sounding like closet Keynesians, you know something’s up.  And that something is reality.  For close on three years conservatives have been singing the same old tired song: cut spending, balance the budget and cap all future federal spending as a percentage of GDP.

Well, it’s finally beginning to dawn on the faithful that there is no way the United States is going to cut its way out of this hole; in fact, it’s been the cutting that’s undermined the recovery in the first place. Attempts at reducing the deficit by slashing spending have actually had the reverse effect.  And as far as capping future federal spending as a percentage of GDP goes, since GDP consists of private consumption, gross investment, as well as government spending, it’s a little self-defeating to slash one of the things that drives up GDP in the first place.  Besides, as any first-year economics student will tell you, you can’t cap a constantly moving target.

So, now what?  With reality, not to mention the upcoming fiscal cliff, staring them in the face, what should Republicans and Democrats do?

Thanks to the Super Committee’s failure to come to an agreement last November, automatic triggers are set to cut $1.2 trillion over the next decade starting in January.  The cuts will be equally distributed between defense and domestic spending. 

Then there are the Bush tax cuts, which are also set to expire in January.  Republicans want to extend all of them for at least a year, while Democrats only want the cuts for middle-class income families earning at or below $250,000 extended.  The Democratic-controlled Senate recently passed a middle class extension, which the Republican-controlled House will undoubtedly reject. 

Who will win this game of chicken?  If I had to guess, Democrats will once more cave on extending all the Bush tax cuts for a year in exchange for a deal with Republicans to stop the automatic triggers and delay any serious cuts for at least a year.  In my opinion, it’s a tradeoff both sides can live with.

The truth is that in a healthy economy the sensible thing to do would be to let the Bush tax cuts completely expire.  Over the next ten years, they will cost the Treasury over $3 trillion while producing little, if any, real growth.  The problem is that this is hardly a healthy economy.  Despite consistent private sector growth, overall demand remains anemic.  However irresponsible it might seem to keep tax cuts on the books that aren’t paid for, now is not the time to take even a penny out of the economy. 

Despite Democratic claims that the rich should pay their fair share – which is certainly laudable – the net result of eliminating the tax cuts for those earning over $250,000 would amount to roughly $30 billion* a year; negligible when considering the overall budget deficit.  The other $270 billion – the lion share – lies in the sub-$250k bracket, or the middle class.  And the last thing the middle class needs right now is a tax increase.

But if extending the Bush tax cuts might be a necessary evil, making sure those automatic triggers don’t kick in is a guilt-edged priority.  While I am certainly no fan of the Pentagon, and firmly believe it needs a crew cut, cutting roughly $60 billion a year from its budget over the next decade, along with another $60 billion in domestic spending, will likely plunge the economy back into a recession.  No matter the risk to the nation’s credit rating, cutting that much spending at this precarious moment in time should be completely off the table.

So, to sum up, for the time being the correct course of action should be to punt twice and delay the inevitable.  The key is demand.  Anything that increases it, even if it means higher deficits, should be encouraged; conversely anything that threatens it should be shunned.  The immediate goal should be to get the economy moving forward.  Short-term debt is sustainable, given the current interest rates.  We already know what happened in Europe.  Why on Earth would any reasonably sane person want to repeat it here?

* Based on 10% of overall tax cut, a number disputed by some, who think it could be as high as 20%.  That would mean a net gain of $60 billion per year.  Whichever number one chooses, the point is that most of the deficit reduction would occur with a complete elimination of the Bush tax cuts.

Links: http://www.huffingtonpost.com/2012/07/30/cutting-government-spending_n_1719675.html?utm_hp_ref=business

http://tpmdc.talkingpointsmemo.com/2012/07/house-dems-to-force-vote-on-middle-income-bush-tax-cuts.php