Stop Worrying About The Fiscal Cliff? Only If You Believe The Fed Causes Christmas

by: Jeffrey Rosen

Goldman Sachs recently issued a research note, "The U.S. Economy in 2013 - 2016: Moving Over the Hump," in which it stated that near-term fiscal austerity could lead to sizable economic prosperity over the next several years. The basis of the firm's argument is the notion that government spending crowds out private spending, and that the easing of government deficits will induce private investment.

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As shown in the above chart -- which Business Insider labeled as the "World's Most Important Chart" -- private savings and government deficits move in opposite fashion. When the government racks up large deficits, private sector savings jump. When government deficits fall, private sector actively leverages for larger investments and consumption.

This means concerns about the potential negative effects of the fiscal cliff may be overblown. Since smaller government deficits lead to higher private investment, the lost spending from austerity will simply be made up through increases in private spending.

If this relationship could be made by only looking at a graph, then a similar conclusion can be developed when looking at the non-seasonally adjusted growth rates of real GNP and the money supply.

Real GNP grows faster at the same time money supply growth accelerates. In other words, large increases in the money supply drive stronger GNP.

This relationship is viewed more easily when separating out the data by quarter. Notice that the strongest GNP and money supply growth rates occur in the fourth quarter.

If increases in the money supply produce stronger GNP growth, and the Fed controls the money supply, then the big GNP expansions in the fourth quarter are ultimately a result of Fed policy.

In effect, the Fed is responsible for the Christmas shopping rush.

Obviously, the Fed does not cause Christmas, but that is one of the dangerous conclusions that can develop when causation between variables is assumed instead of simple correlation.

Fortunately, there are econometric techniques that can tease out the direction and determine which variable is more likely the root cause of the relationship.

Using a Granger causality test between money supply and GNP, it is easily determined that GNP is the main cause of higher money supply. The Fed knows that GNP rises in the fourth quarter from Christmas shopping, and increases the money supply to ease liquidity constraints.

Looking at the fiscal balances, we find that private sector financial imbalances revealed by the Granger causality test cause government deficits, not the other way around.

This means that fiscal policy is being enacted because the private sector is either unable or unwilling to invest or to consume.

In today's economic environment, active deleveraging by corporations and households is preventing economic growth. The government has stepped in as a last resort with increased spending and a larger deficit to keep the economy moving forward.

If the government implements austerity measures, there is no statistical evidence that stronger private spending will expand, let alone completely offset, the economic losses generated from lower government spending.

The IMF came to the same conclusion when it announced its assumed fiscal multipliers were too small and did not properly account for the economic damages from fiscal austerity.

There is no such thing as expansionary fiscal austerity.

Any austerity as a result of going over the fiscal cliff, or even with a compromise on the fiscal cliff, will result in slower economic growth.

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. I have no business relationship with any company whose stock is mentioned in this article.