When I started this blog I set out to write about monetary policy issues – primarily from a none-US perspective – and furthermore I am on vacation with my family in Malaysia so writing this blog post goes against everything I should do – however, after listen to five minutes of debate about the ”fiscal cliff” on CNBC tonight I simply have to write this: What is your problem? Why are you so scared about fiscal consolidation? After all this is what the fiscal cliff is – a 4-5% improvement of public finances as share of GDP.
The point is that the US government is running clearly excessive public deficits and the public debt has grown far too large so isn’t fiscal tightening exactly what you need? I think it is and the fiscal cliff ensures that. Yes, I agree tax hikes are unfortunate from a supply side perspective, but cool down a bit – it is going to have only a marginally negative impact on the long-term US growth perspective that the Bush tax cuts expiries. But more importantly the fiscal cliff would mean cuts in US defense spending. The US is spending more on military hardware than any other country in the world. It seems to me that US policy makers have not realized that the Cold War is over. You don’t need to spend 5% of GDP on bombs. In fact I believe that if the entire 4-5% fiscal consolidation were done, as cuts to US defense spending the world would probably be a better place. But that is not my choice – and it is the peace-loving libertarian rather than the economist speaking (here is a humorous take on the sad story of war). What I am saying is that the world is not coming to an end if the US defense budget is cut marginally. Paradoxically US conservatives this time around are against budget consolidation. Sad – but true.
Since September the Federal Reserve has had the Bernanke-Evans rule in place. That means basically means that the Fed will step up monetary easing in response to any increase in unemployment. Hence, if the full fiscal cliff leads to any increase in unemployment the fed will counteract that with monetary easing. So effectively the fiscal cliff means fiscal tightening and monetary easing. This of course would also be the case if the fed was a strict inflation targeting central bank – that directly follows from the Sumner critique.
Fiscal consolidation and monetary easing is this is exactly what the US had in 1990s – the best period for the US economy since WWII. By at that time a Democrat President also had to work with a Republican dominated Congress.
So no, I don’t understand what there is to fear. Lower public spending and easier monetary policy is the right medine for the US economy (yes and please throw in some structural reforms as well). If that is the fiscal cliff please bring it on. It will be good for America and good for the world. And it might even be a more peaceful world.
PS if you are really concerned about the fiscal cliff just agree on this:
1) Cut US defense spending to 2% of GDP
2) NO tax hikes
3) Commit the fed to bring back NGDP to the pre-crisis trend level through QE
Update: My version (second and third!) version of this post had an incredible amount of typos – sorry for that. I have now cleaned it up a bit.
Update 2: David Glasner also comments on the fiscal issue – David agrees with me in theory, but is more worried about the what the fed will do in the real world. When David is saying something I always listen. David is a real voice of reason – often also of moderation. That said, I strongly believe the Sumner Critique is correct. NGDP is determined by monetary policy and not by fiscal policy – so if the fiscal cliff will lead to a recession the fed will be to blame and not the US politicians (they are to blame for a lot of other things…).