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Which 'Fiscal Cliff' Do We Want?

Friday, 16 Nov 2012 | 2:54 PM ET
Joel Carillet | Getty Images

Hark the huddled Senators sing! Glory to a new budget thing!

So the problem with going over the "Fiscal Cliff" is that it would result in higher taxes and automatic spending cuts, draining both government and private sector contributions to economic growth.

(Read More: What Is the 'Fiscal Cliff?')

Markets supposedly were very concerned that a "deal" might not get done to avoid this outcome. But now we're rallying because there was a nice meeting at the White House that left everyone feel hopeful that a deal would get done.

The outlines of that deal are that Republicans will agree to allow tax hikes to go up while Democrats will agree to spending cuts.

Here's Reuters:

Top Republicans emerged from a meeting at the White House on Friday saying they are prepared to agree to additional revenue in order to avert looming harsh tax hikes and spending cuts, as long as there also are reductions in spending.

"To show our seriousness, we've put revenue on the table as long as it's accompanied by significant spending cuts," House Speaker John Boehner told reporters at the White House.

So why is this different than going off the Fiscal Cliff? On one level, it's not. We're still going to see a fiscal contraction as funds are drained out of the private sector and classified as government "revenue" while funding from the government sector shrinks. In the end, the private sector is left with fewer dollars. We're going off a Cliff either way.

(Read More: Congressional Leaders Voice Optimism After 'Cliff' Talks)

Any difference will be based on the depth of the dive off the Cliff. Any deal likely to be struck will allow taxes to rise somewhat higher than they are now—but not as high and not in the same ways or at the same times as they would without a deal. Spending would be cut—but not as much and not in the same ways or at the same times as it would under the automatic cuts.

In other words, the differences between a Deal Cliff and the No Deal Cliff are about the timing, particulars, and extent of the tax hikes and spending cuts agreed to.

(Read More: Here's Why the 'Fiscal Cliff' Hasn't Been Solved Yet: Bowles)

The stunning thing about this is that almost no one is discussing the obvious choice: not going over any cliff whatsoever. In fact, many are acting like this isn't even an available choice. They talk as if somehow our government has run out of money and we are stretched beyond our economic means.

That's simply not the case. As University of Missouri, Kansas City economist Stephanie Kelton recently put it in a presentation, it is well within our means to simply "step back and think" rather than plunge off any cliff. (Here's her slideshow, you can watch her on C-Span here.)

As Kelton demonstrates, by almost every measure, the United States is living below our means—not beyond it. Our economy is still far below its productive limits. The output gap between our potential and actual economic output is giant. High unemployment demonstrates that we have many people willing and able to work. We can have a healthier, stronger economy if we want it. There's no need to induce a fiscal contraction.

Or, at least, there's no rational need to induce a fiscal contraction. Listening to the many business leaders who parade across our television screens to deplore "fiscal irresponsibility," I have come away with the impression that we could well experience something of a psychologically induced economic contraction. Businesses fearing an "irresponsible" government was jeopardizing our future economic prospects would resist expansion. That monster that's stalked us for so longer—Dreaded Uncertainty—would growl once more from behind the Hermes tie.

It's tempting to say that we might avoid a psychological contraction if people were better informed. But you could also say that the shores of Antarctica would make for a nice summer getaway if they were better located. Perhaps the best option available would be a "grand bargain" that—at least for now—changes nothing at all but is accompanied by the right amount of pomp and circumstance. Let's have those Rose Garden speeches, handshakes by politicians proud of themselves, but call the whole cliff diving episode off.

A deal to take us off the Cliff probably won't lead to immediate disaster. Higher marginal tax rates for the very wealthy won't put a big dent in aggregate demand, even if they create supply-side problems for the longer term. Lower government spending in some areas will sap demand but will also free up resources that may be more productively used by the private sector. We'll be a bit hobbled but we'll get through it.

(Read More: Complete Coverage of the Fiscal Cliff)

Even a No Deal dive will likely not be as dire as markets seem to be attempting to price. The odds are that after the dive, politicians will agree to ameliorate some of the automatic tax hikes and holding back the shears on some spending.

This strikes me as the most likely outcome, in fact. It would allow Republicans to vote for a deal that resulted in higher taxes than under current rates—satisfying the President's demand for 'more revenue'—but that actually cut rates from what they would be under the automatic hikes. This is a bipartisan dream: a tax hike that is also a tax cut.

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