Fiscal Cliff Economics

November 27, 2012 13:00 pm

by Charlie · 27 comments

Today’s Courier Herald Column:

Today, we’re going to take a quick look at basic macroeconomics to help understand why our elected leaders in Washington D.C. see no easy fixes to the “fiscal cliff” issue that will be dominating political news for the rest of the year.  For the three of you still reading after that first sentence, I thank you in advance.

First, let’s understand how we track economic performance in this country.  Whether we’re doing good or bad is largely determined by our growth (or decline) in the Gross Domestic Product.  A GDP growth rate of 3-4 percent is considered robust.  A GDP growth rate under 2% is considered sluggish.  If the GDP growth rate is negative, economic activity is declining and our economy is in recession.  The point is, small changes in our rate of growth determine whether we’re doing very good or very bad.

Now let’s review how this mythical number is calculated.  The customary Econ 101 method is by calculating the amount of spending in four categories:  Consumer Spending, Investments, Government Spending, and Net Exports.

Consumer spending is by far the most significant, accounting for roughly 71% of our $15 Trillion economy in 2011.  Government spending is a not insignificant 20% of the economy.  This includes not only federal spending but state and local government spending as well.  Investment is roughly 13% of the GDP.  This is not only capital investment, but also includes things like inventories businesses are holding for later sale.  It thus somewhat represents future consumer spending and while relatively small, its watched closely because changes in this number can often show which direction  the economy may be headed in future quarters.

If you add those numbers up, you’ll notice they represent 104% of our economy.  That’s because our next exports are negative, representing -4% of our economy.  In short, we import more than we export, and that’s how we account for a large portion of our consumer spending on items made for us overseas.

One of the assumptions regarding basic economic models is that the period above is closed, and that all money generated is spent in the same period.  We – and especially those in Washington – know this isn’t the case.  Thus, basic economics teaches you that if you want to increase government spending, you have to increase taxes (which would then reduce the money available for consumer spending and/or business investment).  Washington figured out a long time ago that they didn’t need basic models when they instead have something called deficits.

Those in Washington know very well that they are more likely to keep their jobs if consumers are happy and the economy is growing.  The two are, after all, closely linked.  At some point over the past few decades, Washington has discovered that they could completely de-couple the amount of money government spends from the amount of money they take from consumers and businesses in the form of taxes.  The gap is commonly known as the budget deficit, and it now represents roughly 40% of the federal budget.

Democrats are generally proposing to tax “the rich” to plug this hole, knowing there isn’t enough money in their proposed tax increase to substantially close the gap.  But by only wanting to tax a relatively small percentage of people, most will feel unaffected and thus remain happy (and spending) consumers.

Republicans claim to want to cut spending, but despite the rhetoric since gaining a House majority in 2010, haven’t managed to find actual places to cut in significant percentages from the existing baseline.

And at the end of the day, a lot of what we see and hear out of Washington from both parties is just that.  Rhetoric.  Because both parties know we have grown quite used to running our economy on borrowed money.  Thus far, our creditors haven’t asked for an increase in interest rates, which would “crowd out” other investment as the natural counterbalance to consumer and government spending.

Politicians of all political stripes know that tough cuts or large tax increases would easily sway the current GDP numbers to a negative position for at least a few quarters.  It’s basic math in the model above.  The problem is, consumer sentiment would likely turn negative during the news reports of these “bad economic times” and a real recession could take hold as a result.

House members are elected every two years, as are 1/3 of senators.  Presidential campaigns are already forming for 2016.  No one really wants to take the risk that “fixing” a problem may cause another one.

And why would they?  Borrowing money is easy.  And talk is cheap.

Noway November 27, 2012 at 1:34 pm

Nice read, Charlie. There are no easy fixes because no politician will actually cut squat. I actually did the heavy lifting here and went back and saw the federal budgets for the last decade or two. You know, not a damn one of them was smaller that the previous years’. Shazam!!! say Gomer Pyle. Politicians in this current debate will say they’ll cut spending but ‘we gotta raise taxes first.’ Trouble is is that the taxes get raise and not one centavo everrrrrr gets cut. This fiscal cliff needs to happen and then about five more after it. And those 47% who we’ve seen that don’t pay federal income taxes all need to start ponying up. “But they are military retirees and SS pensioners” you say. I say, “So freaking what!” Is there something sacrosanct about someone who reaches 65 and they don’t have to pay fed taxes anymore? Seriously. Is a military retiree more important that the guy who retires from Sears? Hell no. To quote/paraphase the hapless Phil Gramm who made this argument in January of 1996 and shortly left the race, “Everybody needs to help push the wagon instead of riding in it.”

SallyForth November 28, 2012 at 11:45 am

Good one, Noway – especially the Phil Gramm quote. The only thing I disagree with is the statement that the 47% are military retirees and SS pensioners. Any of those folks who are still working either part or full-time to make ends meet are actually paying income tax on current earnings. Have you looked at what SS pays monthly recently? Anyone trying to make it in today’s economy on that alone has a tough row to hoe. A large part of that 47% are unemployed who’ve lost their jobs that aren’t coming back, along with the working poor who actually get an earned income check/gift from the IRS, plus what a friend of mine calls “your limp, your lame, your lazy” who just don’t work at all and never have. (He’s SO politically incorrect. :) )

My pet peeve is the 45% of people on SS who are not anywhere close to 65, but are drawing benefits out of the SS insurance reserve funds paid by and meant for age-tested recipients in their older years. Healthy younger spouses and children, along with everything from newborns on up classified as “handicapped” in some way, have in the last few decades been somehow put on SS – a program never intended for such. Younger spouses and children should have to work to 65 like everybody else. Anyone truly disabled to work should be funded via the Labor Dept. Any truly handicapped should be covered under HHS. Where is Al Gore’s SS lock box?!

Noway November 28, 2012 at 4:11 pm

Educate me, Sally. When the 47% stat was bandied about during the election cycle, those who criticized those 47% were scolded by folks who stated that they shouldn’t bust those folks’ chops because many were retirees of some type and SS recipients. Their emotional arguement, I thought, was that ‘don’t get onto them’ because they’ve either reached the magical age of 65 and have anit-tax paying halos now permanently affixed or or they’ve somehow earned a non-taxable status because of their military service. Am I remembering that rational incorrectly? And the EITC (earned income tax credit) is the biggest boondoggle known to God. Why the f*** are we giving the working poor, as they are called, a cent in a type of tax rebate of sorts when they haven’t paid anything into the kitty? May I answer my own rhetorical question? To buy their damn votes and to keep them quiet enough to they do not riot, Greek-style! We’ve been doing that since LBJ’s Great Society. Oh, those Greek style riots? They are-a-coming here! Gar-enteed! When and if anything is actually cut, especially entitlements, you’ll see riots and burnings that will make the Rodney King riots look like a Boy Scout campfire.

I Miss the 90s November 27, 2012 at 3:11 pm

“And why would they? Borrowing money is easy. And talk is cheap.”

And lets not forget Congress’s biggest secret…the debt is not really an issue.

Trey A. November 27, 2012 at 5:46 pm

Nice work, Charlie.

Elaborating on your point: The folks in Washington are tuned into the U.S. business community, economists and the ongoing quagmire in Brussels. When growth is tepid, austerity coupled with tax hikes result in what we have today in Spain and Greece (along with EU member states’ inability to control their own Fiscal policy). No one–not the politicians, the business community nor the economist–wants the U.S. to go down that path. We don’t need to be so extreme. The crisis is not really that dire right now. If debt and deficit had truly reached a crisis level, then the Fed wouldn’t be forcing the interest rates down to zero.

The great panacea for all of our budget troubles is robust GDP growth. Whatever compromise comes out of Washington over the fiscal cliff negotiations will hopefully set the table for this. Lower corporate tax rates are a start. Taxing the rich at a marginally higher rate and closing loopholes are more important for funding needed business-friendly programs (education) than for the near term paying down of the deficit. The stability of actually reaching a medium term solution–i.e. no looming fiscal cliff–will also boost investment and growth.

The bottom line is that no amount of spending cuts nor revenue increases will fix the problem unless the economy is healthy and growing at a strong rate.

If the Federal deficit is like a guy with a bad cut on his hand, the Democrats want to just keep wrapping the wound with greasy old rags and pretend there’s not a problem. The Republicans want to “cure” the guy by amputating his arm at the elbow. What the guy really needs is thoughtful medical attention–stitches, antibiotics and the like.

Scott65 November 27, 2012 at 6:04 pm

I think anyone who looks at how austerity is playing out (objectively) will see that it is a failure. That these countries (Spain, Greece) dont control their currency is more that a footnote here though. Basically in the EU…Germany is controlling the conversation. Germany has a manic fear of inflation…any inflation. The problem with that is the euro is highly over valued in the other participating countries…so instead of allowing modest inflation in Germany you’ve imposed deflation on the countries you mention. The sooner these countries exit the Euro the better (its going to happen…or you’ll have extreme social unrest). It wont be easy, but taking bad medicine once and then moving to growth is far better than continuing to take bits of bad medicine with no growth (like they are doing now)…of course German banks are most exposed so a euro exit w/ default would be less than optimal for them

Trey A. November 27, 2012 at 11:58 pm

Scott65, you and I apparently read the same publications. I completely agree with you until you get to the “sooner these countries leave the better” line. The sooner those countries leave, the worse it is for Germany. When Greece and Spain exit the euro’s value increases, clobbering the German economy, which currently enjoys an artificially weak currency. You’re right: Germany is in the driver’s seat. They could lose Greece, but losing Spain–the monetary union’s largest economy after Germany, France and Italy–would be a disaster.

Dave Bearse November 27, 2012 at 8:02 pm

I understand the Spain’s problem to be the collapse of a housing bubble, and structurally different than that of Greece’s deficit spending.

Growing our economy is the best solution, though I’m uncertain how to best achieve that. Recent experience is clear that tax cuts for the rich are ineffective. I characterize them as rent-seeking via the tax code.

Incrementalism on the deficit is the best approach given the tenuous economy. I support gradually limiting maximum deductions. (“Loopholes” is a misnomer. My understanding is that deductions are largely either home mortgage interest, charitiable contributions, and health care expenses—not what most of us think of as loopholes. That’s not to say there aren’t loopholes within those categories, but I expect closing what are truly loopholes would generate little revenue.)

Phase out mortgage interest deductibility of interest on other than primary residence over say 7 years. Reduce the deductible maximum over say 7 years, and base the end maximum on a formula keyed to market interest rates for modest housing – based on current conditions say 5% on $100,000 – $5,000?, perhaps without requiring itemization to claim. (The current $100,000 maximum is ridiculous. The leverage it facilitated was air for the bubble.) Phase out the capital gains exemption on the sale of the residence, or at minimum limit the exemption to inflation alone up to some maximum.

A limitation of 50% on AGI for charitable contributions seems high. Reduce to 20% perhaps?

Health care may be the most problematic. It would seem mandated affordable insurance would go a long way toward limiting expenses and thus deductibility.

Tax interest beyond some exempted amount, and also capital gains, the same as income (maybe indexing capital gain to inflation), eliminating the concept of carried interest. In the case of interest, base the exemption amount, like that for mortgage interest, on a formula that reflects market rates and modest savings —- currently say 0.5% on $50,000 – $250. Allow taxpayers to simply certify being under the exempted amount, and therefore exempt most working taxpayers from the bother of reporting interest on the income tax return.

I need to think more about phasing out tax exempt bonds. It seems to be an exemption that distorts the efficient allocation of capital and feeds cottage rent-seekers.

I need to think more about deductibility of state and local taxes, but on principal am included to think that deductibility should be phased out to.

The penny-ante deductions such as tax preparation, safety deposit box, unreimbursed milage in connection with employment, etc—scrap ‘em all.

Adopting a chained CPI for Social Security benefits, and increasing SS taxes 0.1% per year for 10 years would close 70% of the SS gap. Use means testing for benefits and/or a small dedicated income tax surcharge on high earners to close the remainder. (I’m not sure how to handle the current 2% reduction—increase at 0.5% per year for four years?)

It may be anethema on both sides of the isle, but increase minimum wage and benefits, and decrease earned income credit. (Taxpayers in my opinion subsidize employers and consumers in low wage businesses, especially in the case of full time worker.)

IndyInjun November 27, 2012 at 6:09 pm

The Fed controls interest rates, not the market. The Fed is buying the debt and essentially says that it intends to buy as much of the debt as it takes to keep interest rates negative in real terms. Fed member Yellen would like to make nominal rates negative. Foreigners have largely retreated from buying US debt, especially the long end.

Also, a big component of “consumer’ spending is government created. For example, the Fed has injected another $16 trillion no one seems to want to talk about to support banks, banks that would have had to take their medicine and lay off 100,000’s of thousands to satisfy market forces. All of those propped up salaries and benefits are reported as “consumer spending” when the funds are spent. Of course the interest that savers no longer have to spend are reported reductions in GDP. The forestalled GDP collapse is everywhere in those numbers.

It looks here like we are all fans of PONZI economics, now. The truth is too gruesome to contemplate.

MATH will take care of all – one way or the other.

Scott65 November 27, 2012 at 6:30 pm

I dont know if foreigners are buying our debt, but someone is because the bond market isnt indicating there is a problem with debt right now…most of the current short term problems are completely DC induced

IndyInjun November 27, 2012 at 7:51 pm

That “someone is the FED, who set itself a limit of 70% (!!! ) and now owns better than 30% of the long bonds.

Foreign borrowing is unnecessary when the Fed creates $trillions in PC and purchases bonds in whatever quantities needed to ‘achieve’ its desired interest rates.

The transition of everybody from ponzi aficionados to gold bugs will be quite stunning.

Trey A. November 28, 2012 at 12:15 am

IndyInjun, after the Great Depression and World War II our debt to GDP ratios were much worse than they are now. And what happened? America’s businesses grew us out of the problem. Same thing happened on a smaller scale in the 1990s.

The problem now is that under Slick Willie we rolled back 60 years of sensible banking regulation when times were really good. Then we cut revenues sharply in the early 2000’s, ratcheted up spending under W (Two wars + Medicare part D) and rode out the post dot.com bubble collapse with the aid of an artificial housing bubble. So now the real economy is adjusting. And government spending is still out of whack.

But, the next generation of those manufacturing jobs that fled are starting to trickle back. The fundamentals of the U.S. economy are strong. Next door, Mexico is booming. Most global economic indicators point to a sluggish U.S. recovery growing more robust if policy makers can push toward stability and sensible reforms. The sky is not falling.

IndyInjun November 28, 2012 at 6:38 am

The demographics were not the same. There weren’t 70 million Baby boomers. WWII destroyed US competitors and created a huge market for reconstruction.

My heart has always been in manufacturing and it is indeed good to see it making a gradual comeback, but then I was reading yesterday that a lot of the new manufacturing jobs are only paying $10 an hour.

Both debt and GDP stats are horribly corrupted. Meanwhile Japan, Europe, and the US are trying to out-devalue each other.

Talk to somebody else about that damnable fiscal cliff. Bernanke and company have stolen 90% of my income from savings.

Indeed, the Clinton era gutting of Glass-Stegall with Gramm/Leach/Bliley and the Commodities Futures Modernization Act of 2000 set the stage for the OTHER $16 TRILLION in Fed-supported banking system debt. Basically the circuits of the financial system got fried and the only thing ‘they’ can do is to try to electronically paper it over and ‘repair’ it on the backs of savers. I have followed this story in depth. If it doesn’t lead to a worldwide revolution, I will be amazed.

IndyInjun November 28, 2012 at 6:43 am

Chambliss, Isakson, and Deal all voted for GLB and CFMA. The first two voted for TARP. I would like to run all 3 out of politics and I damned sure would never vote for any of them.

seenbetrdayz November 29, 2012 at 5:49 am

Ah, a voter with a memory. Here I was thinking I was the last one. Respect. *chest bump* *high-five* and all that.

Scott65 November 27, 2012 at 6:23 pm

You have the following in your piece that is wanting a little:

“One of the assumptions regarding basic economic models is that the period above is closed, and that all money generated is spent in the same period. We – and especially those in Washington – know this isn’t the case. Thus, basic economics teaches you that if you want to increase government spending, you have to increase taxes (which would then reduce the money available for consumer spending and/or business investment). ”

First money can be created as needed by the Fed so taxes are not necessarily required. Second, that printed money goes to a bank before it goes into the economy. The problem is that the money is not leaving the banks in the form of loans, and not getting into the economy…so the velocity of money is low there is no “crowding out” just businesses cant get capitol. Third, effective interest rates are at zero for those borrowing directly from the Fed…so they have little power to lower them.
Our fiscal crisis is one of demand…there is excess “stuff” sittin around and nobody is buying it…thus businesses aren’t spending to make stuff they dont need…I know thats kind of simplistic…but the government is the “spender of last resort” and with interest rates so low and capitol frozen it is the best time for government to be spending on infrastructure and other projects which generate long term returns on investment.
We need to shake off this “all government spending is bad”. Its just not true…every dollar spent here is a dollar someone else is earning.

Trey A. November 28, 2012 at 12:26 am

Scott, you should comment more often. You are spot on.

Business people supported Romney because beneath the rhetoric, they believe he thinks like you do. The problem is, being reasonable and truly business friendly doesn’t work in politics. Romney had to “occupy the shelf space to the right” to get through the primaries and he lost the middle.

seenbetrdayz November 28, 2012 at 5:49 am

More keynesianism. The famous ‘let’s apply for another credit card to pay off our old one’ approach.

The reason no one is buying stuff right now is because they think it fiscally prudent to save their money.

Does anyone know what that word ‘save’ means, anymore?

Charlie November 28, 2012 at 9:23 am

OK, let’s break this down a bit.

The reason that the assumption is made that all money is spent in one period is a teaching tool, not because anyone thinks that happens. It’s a way to isolate the effects as is done in most basic economic models. Assumptions are made that would never take hold in the real world so you can see root economic forces at work.

Money can be created by the fed, but it can also be created by the banks that you think aren’t loaning money. One of the least talked about effects of the 2008 crash was the amount of money that was destroyed by collapsing banks. Even removing the derrivative leverage out of the discussion, a commercial bank operates on a 10:1 leverage ratio. For every dollar of deposit they can make $10 of loans through fractional reserve banking. I don’t have the numbers handy (and too lazy to Google), but let’s just say there was $1 Trillion lost in banking via the housing/banking collapse. That’s $10 Trillion gone from the money supply. Those banks that made it are trying to replace their own capital stock. They’re not sitting on cash, but they do have to ensure that there are credit worthy/risk acceptable loans out there before they place their bets. Uncertainty matters here too.

I agree that not all government spending is bad. Equally important to remember that all government spending is not the same. And all government spending isn’t really “spending” as it relates to GDP. We’ll cover transfer payments in today’s column.

IndyInjun November 28, 2012 at 11:40 am

You are correct. My recollection was that there was something like $4 trillion in FDIC insured deposits back in 2007. I looked. Total deposits were $12 trillion. Collapsing debt should have wiped out bank equity and bondholders and probably would have resulted in maybe 30% losses among the FDIC insured. HOWEVER. the remaining money would have had simply stunning buying power. As you suggest, Charlie, the collapse of debt back into base money would have been massive. Savers were so vastly outnumbered by debtors that we became sacrifices to a collapsing fraud-riddled banking systems. The fraudsters got to keep their jobs and bonuses. We got Zero Interest Rates. Trying to “replace their own capital stock” is off of our backs. All powers that be despise a strong dollar. All finance is predicated on “growth” so when it doesn’t exist they “create” it by lowering the GDP inflation deflator, take food and energy out of the equation, then devalue the currency. All of the forces in play are stacked in one direction.

Bravo to you for earlier endorsing that repeal of Glass Stegall was a mistake. Leverage on the derivative level was not 10:1 but 40:1 and even higher. Most of the securitized debt was worth 5 cents to 35 cents on the dollar because the debt securities also contained things like synthetic CDO’s that were purely fraudulent instruments.

Last week I was reading something that really struck me about why it is totally impossible to communicate what has happened. It is that we became so specialized that there are very few folks with cross-disciplinary knowledge and skills to figure out how all of these pieces come together – or more succinctly WHY THEY DON’T.

Yeah, they can throw $16 Trillion at the banking system to try to make it sound again, but they are doing nothing about the corruption and rot that brought it down, with the most corrupt of the lot, the Fed Primary Dealers getting even more power and authority to expand their theft. This is an epochal change. I find the whole environment fascinating, even energizing. I absolutely do not see the forces of corruption winning, either. Saxby Chambliss’ race will be a GREAT debate because he is at the center of so many bad decisions.

Are we gonna debate or are you going to ban me again?

Scott65 November 27, 2012 at 6:34 pm

Charlie you are a brave man trying to take this on…it gives me a headache responding…cant imagine writing it in the first place

Charlie November 28, 2012 at 9:15 am

It’s good to take the frustrated Econ wonk in me out for a jog once in a while. Spoiler alert: I’m continuing the conversation today. Now let me try to get a decent response to your post above…

saltycracker November 28, 2012 at 7:29 am

We have discussed Keynesian approaches a few times here. This is not what the new left has in mind. They are not about public infrastructure but individual redistribution.
Keynes is rolling in his grave.

The politicians also learned from the too big to fails that there is great personal gain in leveraging up until it collapses and then staying around to “lead” it back. Who else knows better to fix a problem than those who created it ?

Mike Hassinger November 28, 2012 at 8:07 am

“For the three of you still reading after that first sentence, I thank you in advance.”
-You’re welcome!

SallyForth November 28, 2012 at 11:01 am

“In short, we import more than we export…..” And therein lies the rub. Among other economic miscues, America is no longer what it once was in production and sales of goods to the rest of the world. As long as we’re buying more things than we are making/selling to other countries, there is a sucking sound coming from trade imbalance.

Lea Thrace November 28, 2012 at 1:25 pm

“I wish I knew how to quit you!”

Everytime I think about quitting reading PP due to crazy commenters and sometimes (even crazier) posts, someone writes an even handed/level headed piece like this. (And puts it in terms that does not make my head hurt.) Thanks Charlie!

Charlie November 28, 2012 at 4:18 pm

I have a feeling we’re going to destroy your lack of faith in us tomorrow. But for today, thanks.

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