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.
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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…).
rob
/ November 16, 2012“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 is an excellent point that very few people in the debate seem to be making.
I have a question: say for example that budget cuts led to 1m fed employees losing their jobs but this was matched by sufficient QE to prevent this affecting NGDP. Wouldn’t there still be serious structural issues that would mean that RGDP fell somewhat (and inflation increased) as these issues were worked through ?
Lars Christensen
/ November 18, 2012Rob, regarding you question – lets say in a major fiscal consolidation that 20% of all US public employees were laid off tomorrow, but the fed would expand QE to keep NGDP stable – or even increase NGDP to the pre-crisis trend level what would then happen? Well, likely unemployment would rise temporary (RGDP drop), but I strongly believe that the rise in unemployment would be very short-lived.
To some extent this would be similar to what happened in 1946 and US troops returned to the regular labour market after the end of WWII. Keynesians would argue that there should have been a depression in 1946. That was indeed not the case – rather the rise in unemployment was very short-lived. See this excellent article by Vedder and Gallaway on that issue: http://econstories.tv/wp-content/uploads/2011/05/The-Great-Depression-of-1946.pdf
dajeeps
/ November 16, 2012Is the Bernanke-Evans rule really a rule though? I am not sure that it is clearly understood as a rule because it has only been expressed as a desire to reduce unemployment without much definition. The Fed needs to come out with the particulars and make whatever it is targeting very clear. I also think that there might be some fear the FOMC will get cold feet once the PCE starts to rise above 2%. It has all the credibility needed to maintain the 2% target and that is a problem as well.
Lars Christensen
/ November 18, 2012dajeeps,
No you are right – the rule is not clear enough, but at the same time I think it is good that it is not clear enough as long as it is not a NGDP rule. Hence, targeting unemployment is really a bad idea. Therefore, talking in the language of the dual mandate, but not putting numbers on the “unemployment” target makes it possible to de facto target the NGDP level.
Furthermore, even if the fed had a strict inflation target it would have to ease monetary policy in the event fiscal tightening caused NGDP to drop.
dajeeps
/ November 18, 2012I agree. But I don’t feel so comfortable that these guys on the FOMC see the responsibility of their inflation target entirely the way you do. If they did, I’d be blissfully unaware of anything monetary.
Ravi
/ November 16, 2012Off-topic, Lars, but thought you might enjoy this from your namesake: http://www.bis.org/review/r121114c.pdf. If only all policymakers were so thoughtful.
Lars Christensen
/ November 18, 2012Ravi, Yeah I say Lars’ comments. He is surely one of the best central bankers around – even though he is not a monetarist – or a market monetarist. That said, he surely is the sensible part of the board in the Swedish RIksbank.
Benjamin Cole
/ November 17, 2012Malaysia is obviously good for clear thinking.
Yes, the Fed can stimulate the USA economy (and possibly the world’s, if you read Beckworth.
The Cleveland Fed index of inflation expectations is near record lows, and has been trending down for years. That is not a sign of an inflationary monetary policy–quite the opposite.
The Fed has miles of running room.
I wish they would run.
Saturos
/ November 17, 2012Lars, so you disagree with Scott, that the Fed would not do enough to offset? Their new strategy is still quite vague you know.
Lars Christensen
/ November 18, 2012Saturos, If Scott disagrees with my view then he disagrees with himself. After all what I am arguing is just the Sumner Critique: Under inflation targeting, NGDP target or unemployment target the fed will always offset any shock to aggregate demand from fiscal policy. That makes the world “classical” also if we are in a fundamentally keynesian IS/LM world. See my post on that topic here:
http://marketmonetarist.com/2012/09/15/the-fiscal-cliff-and-the-bernanke-evans-rule-in-a-simple-static-islm-model/
Saturos
/ November 18, 2012Lars, see here: http://www.themoneyillusion.com/?p=17557#comment-204802
Lars Christensen
/ November 18, 2012Dajeeps, maybe the fiscal cliff is the excuse Bernanke needs to convince the rest of the FOMC to become more clear on their targets and on how they implement it. The fed has often disappointed us, but I think that there has been a significant move in the right direction since September.
hishamh
/ November 21, 2012I think I made the same point myself in an editorial for one of our local business dailies recently – it’s a fundamental mistake to look at fiscal or monetary policy in isolation.
The reality is that there is really a continuum of policy choices between the two, bounded by the goal of achieving full employment growth. Yet the debate, both here in Malaysia and elsewhere, is almost wholly in terms of fiscal stimulus or consolidation, even among economists who really ought to know better. Too many people thinking in terms of static models and ceteris paribus, and not realising that in the real world what we’re looking at is a dynamic system with reaction functions and feedback loops.
Steve
/ December 12, 2012Lars, a lot of the fiscal tightening is actually hitting this year bc people are shifting income forward. Taxes (in dollars not rate) may very well be higher this year than next.