The Fiscal Cliff, Keynes, Ricardo And Politics

by: Philip Mause

First, let's do something which I haven't seen done very much recently. Let's put the "Fiscal Cliff" in perspective. The table below lists inflation adjusted deficits for various years and periods of time including 2013 with the assumption that we drive off the Fiscal Cliff.

Time Period Deficit (Billions of 2012 dollars)
WW2 High (1943) 728
WW2 Total (1942-45) 2245
WW2 Average 561
Reagan Peak 479
W Peak 501
Korean War Peak 56
Vietnam War Peak 166
2013 No Cliff 1201
2013 Over the Cliff 641
2009-2012 Total 5394
Click to enlarge

A few initial points. While these deficits are inflation adjusted they are not per capita or GDP adjusted and some of the earlier deficits were higher when viewed on a per capita or percentage of GDP basis. In addition, if inflation has been understated, then the earlier deficits would be higher in inflation adjusted terms. Of course, the 2012 and 2013 numbers are estimates.

With all of these caveats, these numbers are rather awe inspiring. If the "fiscal cliff" debate is deadlocked and we go over the cliff, we would still have a higher deficit than the average deficit we ran during World War 2, when we were fighting essentially 2 massive conflicts, supplying the rest of the Allies with materials and equipment, inventing, building and testing the Atomic Bomb and replacing hundreds of ships being sunk regularly right off our shores. Yet, there is a broad consensus that, if we cannot agree and these "draconian" measures are allowed to go into effect reducing the deficit to a mere $641 billion a year, the economy will tank.

1. Keynes - The argument that the economy will tank if the deficit is reduced to a paltry $641 billion a year could be termed an acceptance of "Keynesian Economics". After all, that is the label that has frequently been applied to the theory that deficit spending stimulates the economy. In fairness, John Maynard Keynes was not the first economist to identify the problem of "underconsumption" and suggest deficit spending as a potential solution. He is, however, generally credited (or blamed) with putting these insights into a comprehensive theory. Because he had "identified" all sorts of other market failures and embraced government intervention as a solution, he is generally abhorred by conservatives and followers of Friedrich Hayek (apparently no relation to the better-known and considerably more attractive, Selma). Thus, I find myself a bit surprised at the almost universal acceptance of the notion that reducing the deficit down to a mere $641 billion a year will lead to shuttered factories, higher unemployment and hard times. Does this mean, as Richard M. Nixon put it (I am not sure if this conversation was taped) that "We are now all Keynesians"? And Keynesians of a rather extreme version, if we think that a deficit of $641 billion is insufficient to "stimulate" the economy?

2. Ricardo - Before Keynes and others criticized the classical formulation, we had what was loosely described as classical economics. In this formulation, markets were self-correcting. If demand for a product declined, the price came down and all was well. Jean Baptiste Say formulated Say's Law which, again very loosely, reasoned that persistent unemployment was impossible. If the price of wood comes down, wood cutters will not be unemployed. In fact, they will work harder, produce more wood and new uses will be found for the very cheap wood. It was sometimes confusing to me how economists could believe that deficit spending (especially if the debt is monetized) would not stimulate the economy, but Ricardian Equivalence provides a rationale. Households and businesses will be aware of the deficit and will spend less and save more, because they know higher taxes are on the way. This reduced spending will offset the stimulative effect of increased government spending and render it futile. This always struck me as a rationalization but, more recently, I have come to believe we may have a lot to learn from David Ricardo (no relation to "Ricky Ricardo" in I Love Lucy).

3. Politics - (Here is where I get to make absolutely everyone mad at me.) Ugh! From the sublime to the ridiculous. We have two political parties in the United States and they each cluster around certain central tenets or beliefs. These dogmas are held with moral certainty and are not revised with changes in economic theory nor are they modified when economic circumstances change dramatically. It does not depend upon where in the business cycle the economy is because it is hard to change your religion every 3 or 4 years. The dogmas are the constant and the nation's economic needs are really just "arguments" to be marshaled opportunistically in favor of the dogmas. The Democrats seem to be absolutely in love with the idea that "rich" people (defined as those with "income", however that is defined, over $200,000) should pay more taxes. The Republicans are similarly centered around a belief that the government programs and spending should be reduced ("let's get our hands on something and deregulate it!").

The deficit provides both of these parties with a weapon to wield in favor of what they want to do anyhow. It also creates abundant opportunities for the Democrats to attack the Republicans for cutting taxes to rich people and for the Republicans to attack the Democrats for spending too much money. In order to make these arguments, however, they must each express, in sonorous tones, concern about the "national debt", the terrible burden it will impose on future generations and the need to be "responsible" in bringing it under control. So, in a superficial sense, an observer might think that we actually had a consensus of the two parties that the national debt is a serious issue which must be addressed. And when a writer like me suggests that it isn't, he is treated to excoriation from all parts of the political spectrum. But this seeming consensus is illusory. The problem is that the Republicans really, REALLY, don't want to raise taxes on rich people and the Democrats really, REALLY, don't want to cut spending, so they each must walk a fine line as they mourn the rise of the national debt because if their wails of concern are too convincing it could lead to an unpleasant outcome. The Democrats are serious enough about the deficit to increase taxes for rich people but not serious enough to cut spending and the Republicans are serious enough about the deficit to cut spending but not serious enough to increase taxes for rich people.

This symmetry produces "deadlock" and uncertainty. Households and businesses don't really know what the tax system will look like next year or even 60 days from now. Middle aged people don't know if social security will be altered or if Medicare will be cut. Government contractors are similarly operating in the dark. Electric utilities don't know what kinds of power plants to build. Businesses may or may not someday get a "tax holiday" on repatriated balance sheet cash so they leave the money overseas and wait.

Back to Mr. Ricardo (David, not Ricky). Most economic theories that achieved a significant following have something to say to us. I am not buying any "comprehensive economic theory" lock, stock and barrel but I do believe that it is worth thinking through the possibility that we may be living through an example of Ricardian Equivalence. Here's why. Let me start with a simple example. Assume that there are ten families in my neighborhood and we all know that one of them will be assessed a charge of $250,000 one year from now and that the choice will be completely random. An economist would say that each household has an "expected loss" of $25,000 ($250,000 discounted by the probability of assessment). But if each of the households is "risk averse", isn't it likely that we will each reduce spending by considerably more than $25,000 to brace ourselves for the risk of the assessment? And, therefore, isn't the reduction in spending likely to be considerably more than $250,000?

What does this have to do with our world? We now all live in an expectation of possibly higher taxes and reduced benefits in future years. Every time it is suggested that the age for Social Security be raised or the inflation adjustment to benefits be modified, a middle aged consumer is likely to put aside more money for his retirement. Every time we hear that dividends will be taxed as ordinary income, retirees are likely to cut back on spending. But, you may ask, why do I assume that the American people have become risk averse? The question almost answers itself. Having been through the 2008-09 debacle, people understandably want to brace themselves for the worst and so households reduce spending and save and businesses cut back on capital expenditures. Mr. Ricardo would have a good laugh.

Vice President Cheney said once that "deficits don't matter" and I thought he was correct. But the two political parties, by using bogus arguments about the "national debt" to advance their agendas and produce deadlock, have made it matter. They have scared the American consumer and business owner into hiding. And this makes it necessary to run even bigger deficits to "stimulate" the economy leading to ever more trepidation and saving.

The solution is, in a sense, very simple. Just as the Federal Reserve announces that it will keep rates low for an extended period or until a GDP or inflation target is reached, so too must fiscal policy be stabilized and the National Debt discounted as an important metric of the country's economic health. Tax increases and significant reductions in spending should be forestalled until healthy GDP growth and low unemployment are achieved. If we come out of this with a well educated work force, a solid infrastructure and a good competitive position in the world, it will not matter that the Treasury owes the Federal Reserve several trillion dollars. If we do not achieve those objectives, it will not matter that we have balanced our books.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.