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Monday, November 12, 2012

Safely Descending the Fiscal Cliff

I'm of course referring to the U.S. national debt, and the law that the congress passed in 2011, the Budget Control Act.   This law mandates substantial cuts to many government programs, including defense, and tax increases for most taxpayers.  This is to happen at the beginning of next year, unless congress and the president can agree on another plan for getting the national debt under control.

This has been called the "Fiscal Cliff" because it would throw the economy into recession, due both to the large number of layoffs that would result from program cancellation, combined with the money removed from the economy by the tax increases.

However, doing nothing, and continuing business as usual, is not an attractive option.  The U.S. now owes an amount roughly equal to our annual Gross National Product (GDP).  At the moment this is not really hurting us, because interest rates are very low, so we can afford the interest on the debt.  However, this debt is rapidly growing, since our government spends a lot more than it collect in taxes each year.  This difference is called the deficit.  In order to keep the debt from growing, we need to reduce the deficit to zero.  It does not have to be done in one year; taking a decade might be OK, as long as it is clear that it will happen.  But the longer it takes, the larger the debt will become.  Furthermore, interest rates will not stay low forever, and a growing debt will eventually cause interest rates to rise sharply.

There is no good way to reduce the deficit; but we (the congress and president) can try to choose the least bad.  Let's look at some of the options:

What if we just keep doing what we have been doing, running a large deficit?  At first, nothing special happens, but the national debt will continue to grow, and therefore the interest payments will also grow, and these interest payments add to the deficit.  But that's not the worst of it; what's really bad is that the interest rates will eventually rise, and what's more they will shoot up sharply.  The rates are low now because the U.S. still has a great reputation as a very safe country to loan money to.  If our debt continues to grow we will lose that reputation.  It might take 2 years, or 5 or 10, but once we are considered a risky place to loan money to, the rates will rise, and once they do, we quickly become much riskier, because the rising interest make the deficit worse!  Then we will no longer be able to borrow money at reasonable rates.  Then we will default on some of our debt, or, more likely, very high inflation will ensue, permitting us to repay the debt with dollars that are worth much less.  If either of these things happen, then we will no longer be able to borrow money.   The government will still be able to pay it's bills, but with dollars that don't buy as much, so most Americans will be much poorer.

OK, suppose we simply cut government spending a whole lot.  This is the austerity approach.  If the economy is strong we can cut it a little bit without harm, but most government spending is income to someone, so if spending is cut, lots of people will have less income.  That means they will buy less, and that means layoffs at the businesses that lose that business.  If the spending cuts are small, and if the economy is producing lots of jobs, then those that lose work due to the spending cuts can find other jobs.  But if the spending cuts are large it will tip the economy into recession.

What if we raise taxes enough to greatly reduce the deficit?  This will also be bad for business, since taxes used for deficit reduction are not spent on goods and services.   Depending on the size of the tax hike, and who it is applied to, we may have just a slowdown, or a recession.  Either of those results mean that the tax hike does not bring in the money it is supposed to, since tax collections depend on economic activity.  A slowdown or a recession reduces tax collections substantially, thus it is at least partially self-defeating.

Are there any other options?  I don't think there are any other major options, but a careful mix of selected spending cuts and revenue increases, along with keeping total employment high, gives us our best chance of successfully handling this problem.

A first principle here is that it's very important to keep almost everyone working.  The unemployed do not pay taxes, they do not buy much stuff, and they get money from the government.  All of that worsens the deficit.  When total employment is very high then most businesses have plenty of business, and plenty of taxes are collected, which directly helps the deficit problem.

A relevant fact that most economists agree on is that people in the less advantaged economic classes quickly spend all or most of the money they earn.  Conversely, wealthy people put a large fraction of their earnings into long term investments of various kinds.  Hence if taxes take an extra dollar from a typical wage earner, there will be a dollar less spent on goods and services.  But if taxes take an extra dollar from a rich person, there might be only fifty cents less spent on goods and services, depending on how rich they are and what their spending habits are.  A clear lesson to draw from this is that, if you want to reduce the deficit by increasing revenues, you should get that revenue from the wealthy.

Another principle to consider is how different types of spending cuts will impact the economy.  We want to cut spending to reduce the deficit, but if the economy shrinks as a result, then less taxes will be collected, and we will not get the hoped for deficit reductions.  Since the people with lower incomes spend most of their money quickly, it is self-defeating for the government to reduce their income.  An example of this is unemployment benefits; those are almost all spent on goods and services, so if those are cut, business is reduced and less taxes are collected.  The same can be said of all kinds of federal assistance to poor or lower middle class people.

So if the goal is to cut spending without harming the economy, then we must reduce payments to the wealthy.  In most cases this would also apply to corporations, since wealthy people own most of the shares of most corporations of significant size.  Hence we should reduce or eliminate subsidies that are paid to agribusiness, oil companies, and any other large corporate interests.

What about defense?  The military industrial complex receives roughly one sixth of all government spending.  Can this be cut without harming the economy?  Any cuts will have some negative  effect, but the size of the affect depends on the program.  For example, if we bring soldiers back from Germany or Japan, that has a minimal effect on our economy.  It may do some damage to those foreign economies, and they may then have less money to buy stuff from us, but that is a relatively small effect.
But if we halt production on a weapon system that is ongoing, and has many workers involved, that may have an immediate negative effect.  So my conclusion is that the myriad ways that money is spent on the military and the defense industry, need to be carefully evaluated to identify those which have a relatively small near-term economic impact.  Those are the ones that should be cut.  Of course a related issue is that we cannot cut programs that, realistically, would endanger national security.  However, many people, including myself, feel that our military could be pruned substantially without risk to our national security.

My conclusion is that the way to get the deficit under control is with a careful mix of spending cuts and revenue increases, and which are oriented toward keeping a high level of employment.   This would mean getting most of the added revenue from those with high incomes, and from medium and large corporations.  The spending cuts must be those that have little impact on people with incomes below the U.S. median income.