Maybe Going Off the 'Cliff' Won't Be So Bad
Senior Editor, CNBC.com
The consensus in our nation's capital is that the "fiscal cliff" threatens to bring about economic disaster.
The doomsayer story line — which we hear from both Republicans and Democrats — is pretty much textbook Keynesian economics. The combination tax hikes and spending cuts will create a "fiscal drag" on the economy, sapping aggregate demand and probably bringing on a new recession. At the very least, the conventional wisdom goes, we should avoid staying all the way down at the bottom of the cliff for too long. Some agreement must be reached to reduce both the tax hikes and spending cuts to a level that doesn't tank the economy.
You might have noticed that we did not exactly have a protracted public debate about the underlying economics of this narrative. There's been very little discussion by elected officials — at least in the United States — of the idea that a fiscal contraction could have economically stimulative effects.
This is unfortunate because there is a very plausible version of the economic narrative that concludes that that fiscal contraction can stimulate economic growth, so long as you are in the right place in the economic cycle.
Let's start with the idea of sectoral balances. Goldman Sachs chief economist Jan Hatzius recently explained in an interview with Business Insider the idea, popularized by British economist Wynne Goodley, that accounting balances determine important features of the economy.
Here's how Hatzius puts it:
There is an accounting identity which is issued, if you start with the global economy, to simplify it, that every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector's income is another sector's spending, so it all has to add up to zero.
This is taken by many as supporting the idea that in a recessionary environment, when households and businesses are engaged in balance sheet repair, the government must run a deficit large enough to offset the private sector savings. Someone must be supplying the income going into the savings.
But let's say the private sector has repaired its balance sheet. Households and businesses desire to increase their spending relative to income. In that case, high government deficits would start acting as a roadblock to adjustment and private sector recovery. As an accounting identity, the government's spending and deficit would crowd out private spending and investment. We'd be undermining the private sector expansion by refusing to rein-in the government's deficit.
At that stage of the economic cycle, a fiscal contraction on the government sector side of the ledger would create the room for the desired expansion on the private sector side of the ledger.
But what are the mechanics for this "crowding out" phenomenon? One answer might be the old "Ricardian-equivalence theorem" proposed by the Harvard economist Robert Barro. The gist of Barro's argument is that increases in public debt are offset by decreases in private spending because rational, forward looking people set aside money to pay the taxes they believe they'll be charged to pay for the increased debt.
For a variety of reasons, I've never found this answer satisfactory. For one thing, it's just not rational to anticipate having to pay off all the new dollars spent. In the real world, we're unlikely to ever bring our government debt down to zero. When the United States perishes from the planet, as all governments everywhere have done and will do, we'll certainly have some unpaid debts on our books. Once you allow in the possibility that government debt operates on a Ponzi basis, the Ricardian-equivalence theorem cracks.
A better answer may be that the same psychological forces that lead to private sector deleveraging cause the private sector to "go on strike" until the government sector subsequently delevers. That is, to the extent that the private sector has become allergic to too much debt, it is allergic not only to an overabundance of private sector debt but to debt altogether. In that case, the private sector would attempt to compensate for government budget deficits by increasing its savings — keeping the total borrowing and spending at the desired levels. Government borrowing would drive private sector deleveraging, rendering fiscal policy futile.
The impossible task of policymakers in a recovery, then, would be to aim policy so that it cuts government borrowing to exactly the level of the private sectors' desire to diminish its savings. Cut it too much, and you really do create a fiscal drag. Cut it by too little, and you create a deleveraging drag.
It strikes me as unlikely that going off the fiscal cliff will mean arriving somehow at the right level of fiscal contraction to allow the desired private expansion. On the other hand, I'm no more confident that a deal to avoid the cliff will do any better on this count.
For what it's worth, Goldman's Hatzius, who is paid far more than I am to know about such things, thinks we'd get too much drag from plunging straight off the cliff. But he does think that deficit reduction in 2013 will be offset by private sector expansion such that the second half of the year should see a more robust recovery.
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