One of the hottest political topics in the US today is the so-called fiscal cliff. The fiscal cliff is the expected significant fiscal tightening, which will kick in January 2013 when the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 expires – unless a deal is struck to postpone the tightening. The fiscal cliff is estimated to amount to 4% of GDP – hence a very substantial fiscal tightening.
So how much should we worry about the fiscal cliff? Keynesians claim that we should worry a lot. The Market Monetarist would one the other hand argue that the impact of the fiscal cliff will very much depend on the response of the Federal Reserve to the possible fiscal tightening. If the Fed completely ignores the impact of the fiscal cliff on aggregate demand – if there will be any – then it would be naive to argue that there would be no impact at all on aggregate demand – after all a 4% tightening of fiscal policy in one year is very substantial.
On the other hand if the Federal Reserve had an NGDP target then the impact would likely be minimal as the Fed “automatically” would fill any “hole” in aggregate demand created by the tightening of fiscal policy to keep nominal GDP on track. This of course is the Sumner critique – the fiscal multiplier will be zero under NGDP targeting or inflation targeting for that matter.
Note that I am not making any assumptions about the how the economy works. Even if we assume we are in a Keynesian world, where the “impulse” to aggregate demand from a fiscal tightening would be negative an NGDP targeting regime would ensure that the world would look like a “classical world” (fiscal policy will have no impact on aggregate demand). This by the way would also be the case under inflation targeting – which of course is closer to the actual policy the Fed is conducting.
Said in another we should expect that if fiscal policy indeed would be strongly negative for aggregate demand in the US and push inflation sharply down then the likelihood of more aggressive monetary easing from the Fed would increase and hence sharply reduce any negative effect on aggregate demand (note that nominal GDP is really just another word for aggregate demand – at least according to Market Monetarists like myself). Therefore, we should probably be significantly less worried than some Keynesians seem to be.
Furthermore, it is notable that the US stock market continues rise and inflation expectations have been inching up recently. This is not exactly an indication that the US is facing a sharp drop in aggregate demand in 2013. We can obviously not know why the markets seem so relatively relaxed about the fiscal cliff, but I would think that the reason is that the markets are pricing in a combination of a political compromise that significantly reduces the fiscal tightening in 2013 and also is pricing an increased likelihood of QE3 becoming a reality.
So the conclusion is that Keynesian fears about the scale of the shock to aggregate demand is somewhat overblown as a combination of the Sumner critique and political logrolling will probably reduce the negative shock. We, however, can’t be sure about that so wouldn’t it be great if we didn’t have to worry about this issue? NGDP level targeting could seriously reduce the worries about fiscal shocks.
Fiscal conservatives should endorse NGDP targeting
Both in the US and the euro zone calls for scaling back fiscal consolidation have been growing larger and politicians like the French President Hollande and from Keynesian economists like Paul Krugman and Brad DeLong have even demanded fiscal stimulus. To me it is pretty simple – the state of public finances in most euro zone countries and the US is horrible so I fundamentally don’t think that most countries can afford much fiscal stimulus. That said, I also think that the calls for austerity is somewhat hysterical and I find it rather unlikely that the markets would react very negative if the US budget deficit became 1-2 percentage points of GDP larger next year – just look at US treasury yields it is not so that the markets are telling us that the US economy is on the verge of bankruptcy. The markets are often wrong, but government default rarely happens out of the blue.
However, from a public choice perspective we should probably think that the deeper a country falls into recession the more likely it is that the wider public will vote for politicians like Hollande and policy makers are more and more likely to start listening to economists like Paul Krugman. That unfortunately will do very little to ending the crisis. Fiscal stimulus is not the answer to our problems – monetary easing is.
So fiscal conservatives are likely going to face more and more resistance – whether we like it or not. On the other hand if the central bank was operating a credible NGDP level target then fiscal conservatives could argue that negative impact of fiscal consolidation would be met by an easing of monetary policy to keep NGDP on track. Therefore there would be no reasons to worry about fiscal tightening hitting growth and increasing unemployment.
Even better imagine that the Federal Reserve tomorrow announced that it would do as much monetary easing needed to bring back NGDP to its pre-crisis trend by for example raising NGDP by 15% from the present level by the end of 2013. Do you then think anybody would worry about a fiscal tightening of 4% of GDP? I think not.
Therefore, the conclusion is clear to me. Fiscal conservatives should endorse NGDP level targeting as it completely would undermine any Keynesian arguments for postponing fiscal consolidation. Furthermore, a commitment to keep NGDP on track would also likely make fiscal consolidation much less unpopular and therefore the likelihood of success would also increase.
Finally I would highlight two historical examples of successful fiscal consolidation. In the mid-1990s both the US and the UK undertook significant successful fiscal reforms that led to a significant improvement in the public finances. Both was undertaken while monetary conditions was eased significantly. As a result there was very little opposition to fiscal consolidation at the time and there was basically no negative impact on US and UK growth. In fact both economies grew robustly through out the fiscal consolidation phase. This of course is the opposite of the German experience from the early 1990s where the Bundesbank completely “neutralized” any stimulus from fiscal expansion in connection with the Germany reunification (See my earlier post on that topic here.)
PS Above I have not given any attention to the supply side effects of the “scheduled” tax hikes that follows as a result of the US fiscal cliff. NGDP level targeting would not deal with that problem and the issue should certainly not be ignored. Tax hikes can never increase the long-term growth potential of any economy, but the issue is not going to have any visible impact on real GDP growth in 2013 or 2014 for that matter. Supply side effects mostly work with long and variable lags. Furthermore, I am not arguing that one should ignore the fiscal cliff just because the Fed has the power to counteract it. After all the Fed’s performance in recent years has not exactly been impressive so a political compromise would probably be helpful for US growth in 2013 – at least it would reduce some risks of the US falling back into recession.
PPS this is my blog post #400 (including guest posts) since I started blogging last year.
Market Monetarism vs Krugmanism
Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)
The Bundesbank demonstrated the Sumner critique in 1991-92
“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy