Read of the Day: “What if we go Off the Cliff Just a Little bit?”

The fiscal cliff debate is becoming increasingly contentious as politics come to the forefront.  On the one side, Democrats are increasingly in favor of going over the cliff because that might swing the negotiating leverage in their favor once the Bush tax cuts expire and provide Democrats with the argument to encourage new passage of tax cuts for the middle class (thereby maintaining upper class increases).  Republicans want a deal done quickly so the Bush tax cuts remain mostly in place and aren’t able to expire at year-end.   Of course, the Democrats might be sending us over the cliff if things work out as some desire.  So then the real question is, “what will happen if we go off the cliff just a little bit”?   Neil Irwin of the Washington Post’s Wonkblog has some good thoughts on this:

But that isn’t really the most urgent economic question to ask; no one in government is advocating for all that austerity to take effect permanently. The fundamental question for next year is: “What will happen if we go off the cliff just a little bit.” If we have one, or two, or four weeks of automated austerity, would it really matter?

Some would argue that it won’t be very bad at all. That’s the answer the normal analytical tools would offer. But this is one of those situations where the normal analytical tools might be leading people astray: There is every reason to think even a short exercise in cliff-diving would hurt quite a lot.

“I fear it could be much, much worse than those who blithely assert that it wouldn’t be so bad,” said Michael Feroli, chief U.S. economist at J.P. Morgan Chase.

This also is one of the most important questions hanging over the negotiations, because it is a much more likely scenario than going off the cliff entirely and permanently. It’s also a situation we can’t know for sure, simply because the situation is unprecedented.

In a narrow sense, a short voyage off the cliff shouldn’t crush the economy too badly. The CBO estimates that the full brunt of the policies add up to about $56 billion a month, which is a lot of money — about 4 percent of GDP — but should, in theory at least, do only modest damage to the economy if it lasted only a few weeks. One month of austerity along those lines would subtract only about a third of a percentage point from growth for the full year, before accounting for multiplier effects.

For comparison, the U.S. economy grew at a 1.8 percent rate over the last year; if a single month of fiscal cliff-style austerity had been in place, that number would have been more like 1.4 percent. For a middle income family, based on numbers from the Tax Policy Center, a single month over the cliff would cost $167 — and even that may be completely or partially refunded if Congress makes an eventual deal retroactive, which there is a good chance it would.

Read the full article here.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. It seems to me that most “analysts” are overlooking the fact that even if a deal is made before the end of the year, there is still going to be a constricting effect on the economy. For example, the 2% payroll tax cut will go away no matter what and the medicare surtax on investment income will begin no matter what. Even if a deal keeps everything else at the status quo, there is going to be a fiscal drag in an already weak economy. I am not arguing that this shouldn’t be allowed to happen as recessions are part of life, but why are so few paying attention to this?

  2. This “Fiscal Cliff” noise is looking more and more like a type of QE non event because there are no real assets added to or removed from the system. It’s merely realocating from one place to another.
    I think….(head scratch)

  3. Heckuva an economy we’ve created.
    A tax cut should — or tax hike — should be a neutral event. Either I keep the money and spend it or the government takes it an spends it on someone else.
    What’s really going on here is that we have an economy that can only function if we inject borrowed money into the system. We simply don’t have the resources to finance our desired spending, either as individuals or as a government. So our policy is permanant stimulus by borrowing, either by creating housing bubbles to monetize assets and/or by government deficit spending.
    Shouldn’t we try to create more wealth rather than try to grow by creating money (debt)?

  4. Johnny,
    “The CBO estimates that the full brunt of the policies add up to about $56 billion a month”

    The question is where does this money go, any Idea?
    if it’s simply realocated then not a big deal provided it’s put to some use and not by ipods and cell phones OR pay down the debt.
    Any Idea what it will be used for?

  5. Most government spending is for the Big 3 entitlements — Social Security, Medicare, Medicaid. Then defense. But the entitlements are not affected by the fiscal cliff.

    What’s interesting is that the deficit for the month of October was $120 billion.
    Tax receips were up 12.4 pct since last October. But outlays were up 26 pct.
    So much for rising tax reciepts solving the crisis.

    http://www.reuters.com/article/2012/11/13/us-usa-economy-budget-idUSBRE8AC10320121113

  6. It would be used to reduce the deficit. Remember the sectoral balances. If the govt tries to pull back at the same time as the private sector, it probably won’t end well.

  7. In pure numbers, going off the cliff “a little bit” doesn’t look very scary.

    But impulses (in either direction) do matter in a flow system. Also, psychology matters.

    There are interesting months ahead.

  8. Michael Mauboussin just showed confidence in somthing getting done and he’s the wall street psychcology guy.

    Thought this an interesting talking points and wonder if it’s a vield swipe at the post election electorate:

    “It is an interesting topic when you think about taxes or tax policy. And I’m not going to really take a strong view on this. But let me paint out two extremes. One is if you believe that people’s earnings are a function solely of their effort, of their skill, hard work, then higher tax rates, it is a disincentive for people to work. On the opposite, if you believe people’s earnings are a result of pure luck, then tax rates wouldn’t matter that much. So the question is, what’s an appropriate tax policy given the combination of skill and luck in people’s outcomes in their earnings? And I think that’s a really interesting thing to think about and to discuss.”

    http://www.cnbc.com/id/49821151

  9. Any politician claiming 2008 was caused by people being lazy needs to do the world a favor and resign.

    Sure if you can feed a family in a McMansion with 2 cars in the household purely on gubmint subsidies, there is very little incentive to work. But anyone believing that this is the case needs a hard reality check.

  10. Cowpoke; research has shown that when workers taxes go up, they work harder to make up the difference. They can’t afford to cut back, which would only make their position worse.

  11. Sorry, that’s 5 trillion in liquid assets. Which could translate into less disappearing from the everyday economy depending on what they bought.

    But then there’s the profits ;)

  12. And more overtime = less opportunity for unemployed to find jobs.

    Unless you assume that all the unemployed are entitled lazy bums. Then it all makes sense.

  13. “Reallocation” is what normally happens in recessions. Resources shift from one sector to another; people lose their jobs and have to find new ones.

    Decreasing the deficit also means that we’ll see more deflationary pressure. Evidence suggests that the markets clear less quickly under deflation than under inflation, mostly because of sticky prices, sticky wages, etc.
    People don’t like taking pay cuts, defaulting on loans, etc., which are the ‘easy’ mechanisms for the markets to clear in a deflationary scenario.

    I’m sure that Congress will come up with *something* so that we don’t face the full force of the cliff. Will it be enough, and will it be soon enough? I’m skeptical.

  14. I’ve wondered the exact same thing. We will all see a 2% reduction in our income but what does that typically mean to GDP? I’ve got to think there is sum type of multiplier to personal incomes that can be applied to figure out the total impact to GDP.

  15. The damage is being already. Business budgets have been done as early as August-September for the next year.
    If there is a deal let’s say in January that will affect businss spending by April-May, may be.
    I think we are going to start seeing serious slow down in January.

  16. Probabaly true but in case of higher income earners in fact, they can cut back on services such as cleaning, childcare, kids lessons etc.
    I need a nanny and a cleaning lady but I can’t afford them. Next year I will be able to afford them even less. These are potential jobs not being created in the economy.

  17. In the abstract, what exactly “is” reducing the deficit? Does it mean that more Tresuries are retired than created? Does this mean less ‘spendable’ dollars in the economy in the short run? (long run depending on credit expansion/contraction)

    In the more concrete, does this mean less income from receipients of government spending? And as a result, less spending throughout the economy? Wouldn’t this just cause more unemployment thereby causing tax revenues to decrease further and deficit spending to go back up as more people need assistence via the automatic stabilizers?

    What’s the point of lowering the deficit? It seems completely illogical to me. To me, the logical way to reduce the deficit is through growth. via higher employment which causes tax revenues to go up and need for assistance to go down. But, this requires increasing the deficit in the short term, right?

  18. Reducing the deficit would mean borrowing less in the coming year that in the current year.
    Probably would mean less spendable dollars in this economy (we could debate this); however, I believe that deficits distort the economy over the long term. For example, borrowing money to finance Medicare means the health care costs rise for all of us. And borrowing money to avoid tricky tax reform questions means that tax policy is a drag on growth. Borrowing money to fund wars makes disasters like Iraq and Afghanistan more likely.
    Budget discipline forces the U.S. Congress, which is constitutionally charged with budgeting, would have to make smart decisions about where we allocate our resources.
    The conventional wisdom is that deficits spur growth, which spurs higher tax receipts, which lead to lower deficits. But I believe this paradigm is broken and people repeat it without evidence. It is certainly not happening now.
    The reality right now is that deficit spending is going to entitlement programs, which do not grow the economy.
    I also suspect that borrowing $120 billion a month gives the banks and financial giants enormous leverage on the government. Ben Bernanke and Tim Geithner don’t work for us; they work for Wall Street.
    Lastly, deficit spending destroys the public’s confidence in their government, and, ultimately, the currency. We have a situation now in which the Fed has made borrowing U.S. dollars a stupid investment …. unless, this is the key point, unless we have deflation.

  19. To borrow from The Great Gatsby:
    “They were careless people, Tom and Daisy—they smashed up things and creatures and then retreated back into their money or their vast carelessness, or whatever it was that kept them together, and let other people clean up the mess they had made.”

    Same thing: You believe we can borrow or print without consequences and as a substitute for real economic activity.

  20. The debt that households go into is somehow a different and better kind of debt than govt debt?

    You can have opinions about what the govt spends money on – certainly, but tying it to debt creation is silly.

    The three latest huge changes to the govt balance sheet is:
    1. Bush tax cuts
    2. War on iraq
    3. War on afghanistan

    Without these 3 there would not be a deficit to speak of. Feel free to confirm with any of the “balance the budget yourself” tools out there.

    But balancing the budget NOW in the middle of a recession would just reignite it. Scaling the wars back reduces the deficit a bit. But chucking the bush tax cuts out the window for Joe Worker? Ouch.

  21. Johnny also keep in mind that there is a large scale ongoing outflow of USD from the everyday economy. It’s spelled “profit”. If there is nothing to reinvest in, it stays out of the economy.

    I am in NO way surprised that new money has to be created (or moved from the financial sector) to keep the economy afloat. You get to choose between:

    1. Growing household debt
    2. Growing govt debt
    3. Tax the hell out of the megarich

    You can scratch #1, households only just stopped deleveraging and won’t be taking on huge amounts of new debt soon. #2 is happening. Is #3 likely?

  22. Or the theoretical #4: Print debt free money and helicopter drop on the population OR give to the state so they can lower taxes or rehire some people that have gotten fired over the last 4 years.

  23. Mikael — Of those, I’ll take No. 4. Wouldn’t that be better that spending money into existence with a future obligation, nebulous though it might be?
    Doesn’t deficit spending just send financial instruments to the banks? Why do that?
    You can make the argument yourself better than me, I bet.

  24. Banks mostly on-sell their inventory of t-bonds so it gets held in pension funds and other funds that are feeding the savings of retail investors.

  25. Hey, Cowpoke.
    Here’s an example: Detroit has huge tracts of vacant land that doesn’t generate revenue or property tax reveneue. Why doesn’t the city give me the land and relax regulations and taxes so that I can clear it and build hothouses to grow tomatoes and other vegetables. I could hire local unemployed people and grow a product that people in the city don’t have. Other businesses would spring up to process, deliver and sell my product. Other people would copy my idea. People would build houses to live in the neighborhood.
    A local bank could lend me the money, creating opportunity for loan officers and shareholders.
    … After my business was up and running, the city could tax me, thus allowing them to hire more police officers to make the city safe to live in and bring back even more people.
    Let’s be creative with our regulations and incentives and let people develop their skills and talents.
    OR
    We can issue government debt and send welfare checks to the people in Detroit.

  26. The biggest impact will be the irreversible DOD layoffs, base closures, and furloughs that take place once the “fiscal cliff” hits. I know because I work in a DOD facility (NRL) that right now has only 2 months of funding. If sequestration hits, even for only a few weeks, the place shuts down and never reopens. It won’t matter if Congress retroactively reverses anything. If you are not funded on direct appropriations, once your Job Order numbers go to zero, you are unemployed.

  27. Cullen,

    What does on-sell mean?

    And how does this process you described here feed the savings of retail investors?

    (seems like it could be write-up on its own)

  28. Deficit spending means “borrowing” (via bonds) from whoever wants to buy and has spare money. In the first step it’s banks. In the second step (after onselling) it’s a broad spectrum of “investors”, including financial institutions and pension savers.

    So what deficit spending means is pretty much moving idle money into the everyday economy. I mentioned through wages & transfers earlier, but the govt also buys plenty of services & goods. Either way it goes straight into the everyday economy.

  29. … minus the part of profits that doesn’t recirculate, but that’s ongoing either way and nothing to do with govt spending.