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Sunday, July 22, 2012

'The Fiscal Cliff and Rationality'

Jim Hamilton:

The fiscal cliff and rationality by Jim Hamilton: ...Let's begin by acknowledging the obvious: the United States faces a very significant long-run issue of fiscal solvency...-- if historical policies remain in effect for the next 15 years we are going to be in real trouble. There is no ambiguity about the fact that medical expenditures have been rising much faster than other categories, and that the American population is going to continue to age. The historical combination of existing tax rates and the rising federal role in health care is unquestionably unsustainable.
Although I emphatically agree that America needs to make changes today that change the fundamentals of those long-term trends, I do not think it is necessary to do so with immediate tax increases or spending cuts. As Karl Smith observes, with the current negative real yields on government debt, the government is actually making a profit by running a budget deficit... Granted, we've seen some of the European countries move ... to ... needing to pay very high interest costs very quickly in response to rapid shifts in investor sentiment. The U.S. would face an enormous problem if the same kind of debt flight were to hit our Treasury auction. That's one of the reasons why I think it's extremely important to put in place today policies that permanently change the long-term fundamentals, but whose fiscal bite increases only gradually over time. ...
However... Existing law tries to make the transition all at once with very significant tax increases and spending cuts. These are scheduled to be implemented at the end of this year, a situation that some refer to as "America's fiscal cliff." The tax increases and spending cuts ... sum to over $600 B in fiscal year 2013, a figure that represents about 4% of total GDP...
How big an effect this would have on the economy depends on the fiscal multiplier. ... But even if the multiplier were significantly less than 1, a 4% hit to government spending and consumer purchasing power, in an economy that is struggling to keep the growth rate above 2%, would be enough by itself to put the U.S. economy into recession. ...
What do I expect is actually going to happen? I propose that the key question to focus on is this: in whose interest would it be to see the U.S. go off the fiscal cliff into recession?
The clear answer is: no one's. Democrats don't want to see that happen, nor do Republicans. The logical thing to expect is therefore that somehow they'll figure out a way to modify existing law before January 1, postponing the lion's share of the tax increases and spending cuts for at least another year. ... But the cumbersome process of getting to that outcome will once again exact its own unique toll.

My priors place more weight on bad outcomes than his appear to do, in part because I don't see the political incentives as closely aligned as he does.

But let me turn this one over to you. Comments?

    Posted by on Sunday, July 22, 2012 at 01:44 PM in Budget Deficit, Economics, Politics | Permalink  Comments (42)


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