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Fiscal Cliff and Economics 101 -- A Few Thoughts

by: tmess2

Sat Nov 10, 2012 at 10:26:27 AM EST

As Congress returns to its lame duck session, it is facing one of its self-inflicted problems.  WhenCongress was unable to do its job in 2011 and pass a necessary revision to the debt limit without any strings attached, it instead opted to schedule a mandatory reduction in spending to occur at the same time as a large number of tax cuts where also scheduled to expire -- January 1, 2013.  Doc Jess has her take on how the President (and Congress) should handle this crisis here.

The reason that the fiscal cliff poses a major threat has to do with basic economic math which is why, contrary to the dataless theory of the Austrian School, most econmists accept that Keynesian Economics (while not necessarily the correct solution in all circumstances) has a core of truth.  Grossly oversimplified, Gross Domestic Product (GDP) is the sum of Government spending (on goods and services), private Investment (in capital goods -- equipment, factories, homes), Consumer spending (on goods and services), and Exports minus Imports.  Taxes, both positive (income taxes, excie taxes) and negative (payments to individuals like Social Security), have an impact by reducing the net income available for Consumer spending and private Investment.  Running a deficit reduces the savings available for private Investment, thereby increasing the interest rate, while running a surplus (and paying off the debt) increases the savings available for private Investment, therey reducing the interest rate.   Changes to taxes (altering the rates and altering the amount of "transfer" payments to individuals) alter the net income available for Consumer spending and private Investment.

Using that basic math, Keynesian economics posits the basic theory that the government can use its budget policies to have an impact on GDP.  When other parts of the economy are slacking -- particularly Consumer spending and private Investment -- the government can fill up the slack by reducing net taxes (either by cutting tax rates or increasing transfer payments) or by increasing spending (building more roads, buying more military equipment).  Since private Investment is down, the Government can run a deficit because there are excess savings available.  When the economy is going full steam and threatening to overheat and develop bubbles, the government can take some of the presure off by raising taxes and cutting spending.

Implicit in this basic math is that, for the most part, a change in government fiscal policy only directly impacts GDP att he time that it takes effect and shortly thereafter as the multiplier effect (the fact that those receiving more payments from the government go ahead and spend that money for their own putchases and those from whom those purchases are made go out and make further purchases of their own, etc.).  Some forms of Government spending (like some forms of private Investment) do have a continued effect on GDP -- e.g. spending on roads make it easier to transport the goods being produced and for workers to go to factories and office, spending on research leads to new goods to be produced.  But for the most part, a change to fiscal policy only grows the economy once.  From this basic fact comes a nasty truth, if the policy adopted to stimulate the economy during a recession is permanent (a lower tax rate or increased levels of spending) then you will need to lower taxes even more in the next recession or increase spending even more in the next recession with the result being an ever growing defecit.  If on the other hand, such changes are temporary and gradually expire, the result is a surplus giving you room to adopt stimulus during a recession without running a 1.5 trillion deficit.  In part, because of this basis economic math, the Congressional Research Service has apparently conlcuded that lower tax rates do not cause the economy to grow over the long term.

By adopting the fiscal cliff, Congress scheduled multiple events  -- each of which will tend to reduce GDP individually -- to occur at the same time, thereby having a very big impact on GDP.  Now, whether each of the steps is a good idea individually or not, doing them all at the same time is a very, very bad idea.  The simple solution is to spread out these ievents.

As a possible solution, instead of the payroll tax going up by 2% on January 1, 2013, let it go up by 1% on January 1, and then 1% on October 1.  Instead of cutting spendiing by $100 billion for the remaining 8 months of Fiscaly Year 2013, cut it by $25 billion with another $50 billion scheduled for Fiscal Year 2014 (and further cuts to be made based on where the economy is for Fiscal Year 2015).  Instead of having all of the Bush tax cuts expire now, have some of them expire in March 2014 with the remainder to expire in 2015.  (Yes for budgetary reasons, I would have them all expire in 2015). 

Each of these events will slow the rate of economic growth, but, hopefully, by spreading out the shocks, this formula will avoid tipping us back into a recession.  At some point, of course, we do need to discuss long range budget issues -- what tax deductions and credit do need to be repealed, how we structure entitlement programs to reflect demographic changes, how we fix our infrastructure while we still have roads, what our spending priorities shoujld be.  But any changes should be gradual, not the immediate massive austerity programs that the Tea Party wants that, not surprisingly, have caused economic downturns in several European countries that have followed his extreme idea.

tmess2 :: Fiscal Cliff and Economics 101 -- A Few Thoughts

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various. (0.00 / 0)
1. payroll tax - this is the Social Security tax, yes?  I wish when it's discussed, it would be pointed out that the "payroll tax cut" is damaging Social Security.  The Times did a whole article a day or so ago without mentioning that crucial point.

2. "Taxes, both positive (income taxes, excise taxes) and negative (payments to individuals like Social Security), have an impact by reducing the net income available for Consumer spending and private Investment."

Payments to individuals, like Social Security, increase consumer spending also.  How much more would be being bought if Seniors (13% of the population the last time I looked) living on savings weren't cutting back spending to the bone because of the invisible interest their savings were earning?  Perhaps I am not parsing your sentence correctly?

3. "Running a deficit reduces the savings available for private Investment, thereby increasing the interest rate,"

What interest rate would that be that's increasing?  The 1.75% my credit union is offering on five year CDs?  The one that used to be 6%?

Payroll Tax & Interest Rate (0.00 / 0)

Yes, that would be the social security tax, but the cut is not directly damaging social secutiry, because the act cutting the payroll tax requires general revenue to still issue bonds to social security as if the tax was being collected, so the tax cut has no impact on the trust fund.   Any impact is indirect to the extent that people realize a disconnect between the trust fund and actual social security revenue.

On the interest, I did say oversimplified. Three basic issues:  1) but for government borrowing interest rates might be even lower; 2) there is a difference between what a bank pays its depositors for their deposits (which are not investments, but rather the pool from which the bank makes loans for investments) and what a bank or those purchasing bonds or those purchasing stock demand as an effective interest rate on their loans/investments; 3) as noted elsewhere, that is why government debt is not that bad during a recession because nobody else is demanding to borrow, when others are demanding the same funds, interest rates can increase. 

Additionally, the one country macroeconomic model is somewhat simplistic (as noted by pretaltz) in a globalized economy.  The pool of potential savings is larger than one country, thus individuals (and governments) engaging in borrowing can borrow from another country's savings and individuals who save can invest in another country.

[ Parent ]
Another thing to consider (0.00 / 0)
As the economy becomes increasingly globalized, the indirect effects of fiscal policy become correspondingly diminished.  

Take for instance interest rates.  It might seem like the amount of debt the government has to issue[supply] would have a rather direct impact on interest rates.  But if you consider US treasuries as just a part of a larger market of sovereign debt or even highly safe debt then it is just part of a much larger market.  So if we increase our debt 10%, we are really only increasing the overall supply by perhaps 1-2% which one would expect to have a much smaller effect on interest rates.  Of course if every other supplier increases their supply 10% than total supply will increase 10% and have a larger effect on interest rates.  So then the question is how much should the federal government base its decisions on actions by actors over which it has no control.  It is in reality a huge prisoner's dilemma game.

seems like the simpson bowles ought to not be the President's opening gambit. (0.00 / 0)
From where I sit, he should open with a statement saying he would prefer a reasonable balanced plan, but he is fully willing to allow the congress to fall on their own sword at the end of december and let taxes rise across the board. he plans to shuffle as many funds as possible to allow the cuts to be delayed while he will let the expiring tax cuts expire.

He then can offer a 1 for one plan, for every dollar in revenue raised, he will agree to a dollar cut in spending, with half of the cuts to be targeted defense items, and half to be targeted cuts in non defense spending. take it or leave it. if the congress wont play obamaball, he lets them raise taxes on ALL americans.

if they will play, he can offer to raise taxes to pre W levels on all over 250K, reverse the payroll tax cut and lift the cap on income subject to SS/MC. whatever that totals, cut military, after a thorough search for non critical expendures, from my perspective, there are no social programs that need to be cut, but i dont think most of america or even most elected democrats feel that way, so we carefully cut there, too. as an aside, i would insist on getting a debt ceiling deal that lasts maybe until jan 1st 2015! or maybe until october 2014, so the congress can run with the debt ceiling hanging over THEM!!!!!

tell what i am missing?




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