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By Ron Rimkus, CFA

In physics the term “observer effect” refers to the changes that the mere act of observation may have on the phenomenon being observed. For example, in order to measure tire pressure, you need to let some air out to insert the gauge.

In economics, the observer effect is writ large. Not only do economists influence markets and asset prices, but also high-profile economists like Ben Bernanke and Mario Draghi are important parts of the very system they are studying. So, their choices influence outcomes and certainly help shape the world in conforming to their views of what will happen.

As the year 2012 winds down, there is a great deal of uncertainty about the future direction of the United States. What is certain however, is that recently reelected President Obama faces a large “fiscal cliff” at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect. As of 1 January 2013, taxes are set to spike through the lapse of the Bush tax cuts of 2001 and 2003, the end of the payroll tax cut from the Obama administration, the end of certain tax breaks for businesses, and the escalation of taxes related to the funding of the Patient Protection and Affordable Care Act (also known as Obamacare). Against this backdrop of higher taxes, federal government spending cuts will also go into effect — covering more than 1,000 different programs, including large “automatic” cuts to defense spending and Medicare, among many others. In short, the fiscal cliff is an austerity program of sorts.

To grapple with the possible impact of the fiscal cliff we must answer the following questions:

  • What is the likelihood that U.S. Congress will address the fiscal cliff before it goes into effect?
  • How bad is the current fiscal deficit situation in the United States?
  • What has been the impact of austerity programs historically?
  • Is there anything terribly unique about the situation in which the United States finds itself?

The U.S. Congress was clearly reluctant to address the fiscal cliff before the elections. Some even argue that this is entirely a manufactured crisis that will soon be addressed, albeit on a temporary basis, by an act of Congress after the election. Without handicapping the odds, it is perhaps more useful to look at the decision tree: If Congress addresses the issue by maintaining the current tax and spending policies, we will get more of the same economy we have experienced for the past three years (all else being equal). But what if Congress lets the fiscal cliff hit? This blog post is designed to asses the impact.

To put the fiscal deficit into proper perspective, consider the history of U.S. fiscal surpluses (or deficits) as a percentage of GDP since 1947.

United States: Fiscal Surplus (Deficit) as a Percentage of GDP

(click to enlarge)
(Click to enlarge)

Sources: BEA, CFA Institute.

First, note how the United States immediately drifted from regular fiscal surpluses to fiscal deficit after it exited the gold-exchange standard in 1971. Second, the United States is clearly in uncharted waters at present, with the average fiscal deficits since the 2008 financial crisis amounting to about −8.3% of GDP. It is believed by many — including the Congressional Budget Office — that the Budget Control Act will cut the deficit nearly in half, to approximately −4.2% of GDP. The questions that the markets are wrestling with now is what impact the reductions in government spending will have on the U.S. economy and what impact the sharp escalation of taxes may have. Of course, these changes are happening simultaneously, so it is instructive to separate them for the purpose of analysis.

Now consider the equation for GDP:

GDP = Consumption + Investment + Government spending + (Exports − Imports)

But this equation cannot be viewed in isolation. The GDP equation includes government spending, and it is easy to fall prey to the simplistic notion that more government spending translates into more GDP. Because government spending is a function of many things, including the ability of the government to finance itself, it can have a direct impact on the other variables in the GDP equation. As noted in my piece on Japan’s looming debt crisis, governments finance themselves through some combination of direct taxation of citizens, taxation of businesses, tariffs on imports from other countries, buildup and usage of foreign currency reserves from international trade, issuance of debt, and money printing — as illustrated in the following graph.

(click to enlarge)
(Click to enlarge)

Changes in each of these components of government finance can impact consumption and investment, as well as exports and imports (not to mention exchange rates). So, as government spending rises, it may cause spending on consumption, investment, and/or net exports to fall. Moreover, monetary and fiscal policies designed to offset any negative effects of stimulus have numerous trade-offs themselves. For example, the Fed’s explosion in the monetary base has caused a substantial increase in the prices of many commodities relative to other goods, slowing both consumption and investment from what they otherwise would be.

Another issue relates to tax policy. For instance, as marginal tax rates come down, does aggregate tax revenue to the government fall — or rise? Recent work by Thomas Sowell of the Hoover Institution highlights numerous historical examples in which decreases in marginal tax rates have increased aggregate tax revenues to the government by material amounts. It is clear in many historical situations that high tax rates have encouraged both legal (and perhaps illegal) tax evasion as well as discouraged productive investment of capital. These are important concerns because the sensitivity to tax rates directly affects the amount of investment and consumption that take place within the GDP equation.

Considering all these interrelationships among the variables of GDP, it is not possible to create a general rule as to what might happen without more information. Government activity can be productive in some areas and counterproductive in others. So, which areas are getting cut? How productive or counterproductive is a particular government on average? Comparable tax hikes in the United States and Uganda might have radically different effects on the economy. The question, as always, is whether the specific programs or projects are productive uses of capital. So, talking in broad brush strokes is useless.

What is perhaps most troubling about all the discussions of how GDP responds to government spending is the absence of a discussion of the debt the government borrows to achieve GDP growth. Combined with easy-money policies from the U.S. Federal Reserve, the private sector splurges on debt too. Aggregate credit outstanding in the United States is $56 trillion compared to a U.S. economy (i.e., GDP) of $15 trillion — and aggregate credit is growing at about 5%, while GDP is growing at about 2%. So, the absolute increases in debt are greater than the corresponding absolute growth in GDP. So, where is that incremental money going? Are companies taking out reams of new debt only to place it in cash on their balance sheets? It seems unlikely — nor is it supported by the work Jason Voss, CFA, has done on corporate balance sheets. Or is it a reflection of the inefficiency of government spending today?

The fiscal cliff issue raises some very fundamental questions about the role, the capabilities, and the limitations of government. Government should spend money on things where the private sector cannot organize and perform efficiently on its own (e.g., establishing a common defense, building an interstate highway system, or creating rules for laying utility lines or fiber optic cable, etc.). Also, government should invest in projects in which the government can employ that capital more effectively than the private market. (I also believe that governments should preserve the rights and freedoms of every individual, but this condition is not necessary for this discussion.) So, these questions become the benchmark for judging existing government spending and whether or not increases or reductions in government spending are good or bad. The Budget Control Act makes cuts across the board, so the question becomes how productive or unproductive is government spending right now.

Recently, the International Monetary Fund came out with an analysis which suggests that the multiplier on government spending is greater than previously believed. The old rule of thumb for the multiplier was that it is about 0.5 (depending on your source). Their new estimate is somewhere between 0.9 and 1.7 — meaning that $1 billion in incremental government spending translates into somewhere between $900 million and $1.7 billion of GDP growth. But this analysis does not address the accumulation of debt and whether or not the additional debt is creating larger and larger problems to be faced in the future. In “Government Debt: A Gentleman’s Wager,” I demonstrated that the incremental debt the U.S. government is taking on is highly inefficient at the macro level.

So, it seems that the exclusive focus on GDP is misplaced. A complete financial picture includes the balance sheets of consumers, corporations, and governments. But then again, I’ve just made the observation and published it ... so maybe now it has all changed.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: The U.S. Fiscal Cliff: Gauging The Observer Effect