Fiscal Cliff Realities

by: Tom Lindmark

Well Christmas Day is winding down and you know what that means, yep back into the fiscal cliff mania Wednesday morning. Turn on Squawk Box in the morning and you can bet the lead story is going to be whether the politicians are all flocking back to Washington to clean up the mess or sitting out in front of their fireplaces at home. The requisite economists and stock pickers will parade forth and describe in detail the descent into at least the fourth ring of Hell that will ensue if we don't tax rich people more. Fortunately some aren't quite buying into this bit of media/political theater. John Cochrane has more than a few worthwhile thoughts.

How terrible will it be if we go over the cliff?

Bad, but for all the wrong reasons. If you, like me, didn't think that "stimulus" from government spending raised GDP in the recession, you can't complain that less government spending will cause a new recession now. The CBO's projections of recession are entirely Keynesian. Pay them heed if you still think the key to prosperity is for the government to borrow money and blow it.

There are no "cuts" in sight anyway. "Cut" in Washington means "increase spending less than we previously said we would." At worst a few programs will have to spend the same amount this year as last before spending increases resume.

It's not even obvious that the "cuts" will happen. Will Congress really try to pay doctors 1/3 less? (Will doctors take any medicare patients if they do?) Or will they pass an "emergency" bill, exempting doctors just like Social Security? Sequestration has never actually been used.

To an economist, the main worry is that higher marginal tax rates mean more distortions, which are a drag on the economy. But distortions take a while to kick in. It takes a while for people to change to easier jobs, not start businesses, move businesses offshore, not go to school, choose easier but less rewarding majors, find more tax shelters, and so on. So the danger is not so much a recession, which comes, and then ends, and we go back to growth. The danger is settling in to a decade of (even more) high-distortion, sclerotic growth.

Cochrane makes the point that we have effectively erected a European style social welfare state (ACA is the last block which was needed to complete the edifice) and are now essentially engaged in a debate of how to pay for it. The current contretemps is simply the beginning of a series of battles to pay for the benefits we have bestowed upon ourselves. One would like to think that those discussions would involve the extent to which we can afford those benefits but there is little to suggest that will occur. Witness the current battle with its emphasis on disaster and vague promises of spending reductions sometime in the future.

I don't like it much but Cochrane's assessment of the current state of the battle is probably realistic.

I think the deck is stacked towards the large-state camp. There were two theories: "Starve the beast" said, cut taxes and eventually the size of the state will have to shrink. "Vote the benefits" said, increase spending and regulation, and eventually taxes will have to be raised to try to pay for it all. The latter seems to be winning.

"Starve the beast" hasn't worked because the beast just borrows the money. When it began to look as if folks were getting worried about running up all that debt, the "large-state camp" rolled out the argument that all would be well if more revenues were extracted from the rich which sells much more easily than any suggestion that perhaps we cannot afford to go where we have gone.

I wouldn't call it a glass half-full alternative view, maybe more a glimmer of hope, but at the state level reality is being sporadically faced. Constrained by constitutional requirements for balanced budgets and lacking a central bank to print money for them, some states are in fits and starts beginning to reign in the benefit train. To be sure some of the saddest cases, California and Illinois for example, have opted for the federal model and are attempting to raise more revenue from a squawking goose. The jury is far from in on the results, and it's not irrational to expect Washington's assistance in perpetuating the status quo, but at least an alternative is being tested.

I wouldn't become overly excited about the coming fiscal cliff. We can fall off and probably find it was more of a curb. That doesn't mean the real one won't come along sooner rather than later when there just isn't any more money to borrow or squeeze out.