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Friday, December 28, 2012

'Falling Off the Fiscal Cliff '

Jason Saving, a senior research economist and advisor in the Research Department of the Federal Reserve Bank of Dallas, discusses the economic consequences of going over the fiscal cliff (see also Over the Cliff We Go for Brad DeLong's views on this issue). After detailing the components of the cliff and noting they amount to $560 billion in budget cuts or tax increases for 2013 alone (though they wouldn't all kick in at once), he notes:

... Interestingly, the various components of the fiscal cliff don’t contribute equally to these negative economic impacts. For example, it might appear that letting the 2001/03 tax cuts expire would have a large impact because this component is among the biggest fiscal cliff budget items, as detailed in Chart 2. However, the cuts are estimated to have the fourth-largest impact, behind the sequester, labor-market provisions and AMT patch.

The reason is that, in the short run, different fiscal policies can have a very different “bang for the buck” (often referred to in economic shorthand as a fiscal “multiplier”). When the government reduces its purchases and lays off workers, as would occur under the sequester, there is an immediate and sizable reduction in demand that feeds back into the overall economy — that’s why the impact of the sequester on GDP is so large. Marginal rate cuts have the smallest multiplier because they flow disproportionately to higher-income individuals, who make the “wrong” choice from a short-run point of view and save those funds instead of spending and pumping them back into the broader economy.[3] ...

He concludes with:

In fiscal policy as in monetary policy, it’s necessary to carefully weigh short-term gain against long-term pain, often when no unambiguously optimal options are available. Many have suggested that the best strategy may be visible, loose fiscal policy today, coupled with strongly worded promises to embark upon fiscal consolidation as soon as it becomes reasonable to do so. But what’s reasonable is not always apparent, making such proposals easier said than done.

Perhaps the real question today is whether we have entered an era of permanently greater polarization in Congress and permanently higher fiscal policy uncertainty. If that’s the case, today’s fiscal cliff may be a harbinger of what’s to come.

    Posted by on Friday, December 28, 2012 at 10:33 AM Permalink  Comments (20)


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