The Washington Post has been as aggressive as any Republican in Congress in hyping the dangers of letting the Bush tax cuts expire. It has run numerous front page pieces telling readers of the dire consequences of letting January 1 pass without a deal (e.g. here and here). Today Wonkblog warned us of the real bad news of going off the fiscal cliff!
Just in case you didn’t understand the Post’s official line on this, the headline of the piece is “the economy (probably) can’t survive a short dive into austerity crisis.” It starts with some clearly mistaken economics. It calculates the hit to the economy of higher tax with-holdings for the month of January.
In a narrow sense, a short voyage off the cliff shouldn’t crush the economy too badly. The CBO estimates that the full brunt of the policies add up to about $56 billion a month, which is a lot of money — about 4 percent of GDP — but should, in theory at least, do only modest damage to the economy if it lasted only a few weeks. One month of austerity along those lines would subtract only about a third of a percentage point from growth for the full year, before accounting for multiplier effects.
For comparison, the U.S. economy grew at a 1.8 percent rate over the last year; if a single month of fiscal cliff-style austerity had been in place, that number would have been more like 1.4 percent.
The problem with this arithmetic is that consumption is unlikely to respond in any measurable way to a one-month tax hike. There is a big debate among economists as to how much consumption responds to temporary tax cuts, like the Make Work Pay tax cut that was part of the initial stimulus package. Many economists, especially those who seem to be most worried about the “fiscal cliff” right now, argue that consumption responds little or not at all to tax cuts that are scheduled to be in effect for a year or two. One doesn’t have to agree with this strong position to accept the view that a one month increase in taxes will have a minimal impact on people’s consumption patterns.
This is especially likely if the tax increase is likely to be reversed the next month, which would almost certainly be the case, as the column acknowledges in the next sentence. So, this arithmetic exercise gets us essential zero hit from jumping over the fiscal cliff.
But wait there’s more:
But all this seems like a naïve way of viewing the situation, one divorced from the real ways that markets and psychology interact with economic forces.
Okay, economic reality is “naive,” now we will get the Post telling us whatever it goddamn pleases under the guise of market psychology and trying to convince readers it is talking about the real world.
Here we go plunging into WAPO psycho-economicsland:
There are plenty of actors in the economy who either haven’t followed the buildup to the fiscal cliff at all or have done so with only a wary eye and crossed fingers. In a slew of corporate earnings conference calls in recent weeks, executives of major companies have mentioned the fiscal cliff as one of the many looming threats, but rarely offered comments more detailed than ‘we hope and expect that the politicians will solve it.’
‘As we consider 2013 today, let us assume that a solution to the fiscal cliff will be found,’ said Arne Sorenson, chief executive of Marriott International, in its earnings call last month.
It is easy to imagine that if there is no solution, the Sorensons of the world will reconsider their own capital spending and hiring plans; even a few weeks in which Washington allows dramatically tighter fiscal policy could lead to a haze of uncertainty and delay as that basic assumption — that at the end of the day, after all the sturm und drang, the politicians will deliver a compromise — proves untrue.
Get that, “it is easy to imagine” line? I suppose in WAPO land it is easy to imagine lots of things.
But lets instead imagine that the Sorensons of the world are sober businesspeople who have some grasp of reality and can do things like, well, read newspapers. They might be disappointed to find out on January 1 that there is no deal, but they would likely see the New Year’s Day paper filled with articles that have quotes from President Obama, Speaker Boehner and the rest of the gang telling us how they are going to resolve this dispute and that they are close to reaching a deal. In this case, they would probably continue with their business as though a deal is about to be reached, which everyone (including the Post) agrees is true.
Okay, but we are not out of the woods yet.
Financial markets, if the past is a guide, will only reinforce these trends. When Standard & Poor’s downgraded the U.S. government’s credit rating in August 2011, citing a dysfunctional process for resolving the debt ceiling standoff (a deal that set the stage for the current negotiations), there was no apparent damage to the government’s finances — borrowing costs actually fell — but plenty of extra volatility in world financial markets.
Markets don’t like risk. And for the world’s largest economy to adopt a yo-yo approach to fiscal policy — steep tax increases and spending cuts one month, a reversal the next — would be an extra layer of risk for already jittery markets. A falling stock market hammers both households’ wealth and confidence and businesses’ willingness to invest.
Who knows if a few weeks of austerity would cause a recession or merely a soft patch in growth. But with unemployment at 7.9 percent, neither is particularly welcome. ‘I don’t know whether reversing this in a few weeks would turn the business cycle around like turning on a switch,’ said Feroli, ‘but it seems like losing this gamble would be very costly for everybody [Feroli is Michael Feroli, chief U.S. economist at J.P. Morgan Chase].’
Okay, so now we have the Post telling us that it knows how the financial markets will react — and they have the chief economist at J.P. Morgan to back them up. Of course they could be wrong, as they acknowledge, but we better not risk it.
There are three points here. The first is the usual one: “if you’re so smart, how come you’re not rich?”
The WAPO doesn’t know how financial markets will react, they are guessing. Financial markets act in crazy ways in response to all sorts of things. The huge stock market crash of 1987 was not traceable to any obvious set of economic events. Apparently the Post is unaware of it, but the volatility in financial markets in August of 2011 was likely due to Italy joining the list of euro crisis countries as interest rates on its bonds soared. (It’s hard to get news about Europe in Washington.) Interest rates on U.S. Treasury bonds plummeted. That is not the reaction that one typically expects from a downgrade.
The second point is that the impact of short-term gyrations in financial markets is minimal. A stock market that falls for a week or two will have minimal effects on consumer and business spending. (The stock market generally has minimal impact on business spending, contrary to media hype on this topic.) Presumably any slump from over-reacting markets will be reversed when Congress and the president sign a deal. Even the crash in 1987 barely impacted growth. The economy grew at a 7.0 percent annual rate in the fourth quarter of 1987.
Okay, but why take any risk at all, after all the economy is weak, as everyone agrees. There are two points to be made here. First, the economy is weak. So why are the serious people at the Post and in Washington obsessed with deficit reduction? The interest burden of the government debt is near a post-war low. It seems really silly for the government to be focused on deficit reduction at all right now, as Mr. Feroli’s comments would seem to imply.
Source: Bureau of Economic Analysis.
The second point is that there is a reason to take a risk, which seems minimal when we focus on the evidence rather the things that are “easy to imagine” at the Post. The issue is more than $700 billion in tax revenue from rich people over the next decade. If the rich don’t pay it, the rest of us will, since it is unlikely that we will get the folks in Congress to raise their deficit targets by this amount.
So the question boils down to whether the rest of us want to lose $700 billion in taxes or from programs that benefit the middle class, like Social Security and Medicare, or do we want to take the Post’s imaginary risks associated with letting the tax cuts expire. The choice is yours, America!
Dean Baker is co-director of the Center for Economy and Policy Research. He also writes a regular blog, Beat the Press, where this post originally appeared.
Photo by SEIU International.