Thoughts from the Frontline

The Perils of the Fiscal Cliff

By John Mauldin

October 23, 2012

Choose your language

The Problem with Austerity
The Perils of the Fiscal Cliff
If Something Can’t Happen…
GDP = C + I + G + Net Exports
Economic Indicators for the Election – It’s the Economy, Stupid!
Brazil, Uruguay, Argentina, Chicago, New York, and North Dakota

“Spain is not Greece” – Elena Salgado, Spanish Finance Minister, February 2010

“Portugal is not Greece” – The Economist, April 2010

“Greece is not Ireland” – George Papaconstantinou, Greek Finance Minister, November 2010

“Spain is neither Ireland nor Portugal” – Elena Salgado, Spanish Finance Minister, Nov. 2010

“Ireland is not in ‘Greek Territory’” – Irish Finance Minister Brian Lenihan, November 2010

“Neither Spain nor Portugal is Ireland” – Angel Gurria, Secretary-General OECD, Nov. 2010

“Italy is not Spain” – Ed Parker, Fitch MD, June 12, 2012

“Spain is not Uganda” – Spanish PM Mariano Rajoy, June 2012

“Uganda does not want to be Spain” – Ugandan foreign minister, June 13, 2012

            Having been to all the countries listed above, with the exception of Uganda (although I have been to 15 countries in Africa, several bordering Uganda), I am most happy to confirm that they are all different. Just as you would grant me the fact that the US is not the UK and that France is not Argentina. To paraphrase Tolstoy, dysfunctional countries come by their unhappy sets of circumstances in their own individual ways.

            How does one go about comparing the financial crisis in one country to that of another? The International Monetary Fund tried to do just that, setting off a rather torrid debate in economic circles. And while we will look today at their analysis, the upshot is that the economic models used to guide monetary and fiscal policy may not be working as they did in the past. Last week in this letter, I postulated a condition I called the Economic Singularity. Just as the singularity at the center of a black hole creates a region where mathematical models break down, a large mass of debt will create its own Economic Singularity where economic models no longer work as expected.

Given that within a few weeks a very large debate will erupt in Congress about how to deal with the “Fiscal Cliff,” with both sides displaying economic models that demonstrate the clear superiority of their chosen solutions and the utter disaster that will ensue if the opposition’s plans are enacted, I think we will find it useful to look at some of the underlying assumptions. Given the fact that almost everyone, including your humble analyst, has concluded that if the tax increases and spending cuts were to be enacted as the legislation currently dictates, a rather serious recession would follow in short order, it might help us to look at some of the assumptions behind that assessment.

In today’s letter we’ll peek over the Fiscal Cliff and see what economic models can tell us about government spending. And if we have time we’ll quickly look at an interesting study that uses economics to predict the outcome of this US presidential election.

At Mauldin Economics we have a laser-like focus on estimating what the economic climate will be in the coming year. As a bit of a preannouncement, I’ll be doing a Post-Election Summit Conference on November 20 with a few of my friends, looking at the likely direction of the economy with the certainty of the presidential and congressional elections behind us. It will be a free seminar, cosponsored by my friends at Real Clear Politics (www.realclearpolitics.com) and available on the Internet to those who register. I’ll give you more details as we get closer, but this is something you won’t want to miss. And now let’s hang our toes out over that Fiscal Cliff.

The Problem with Austerity

            The chief economist for the International Monetary Fund, Olivier Blanchard, and his associate Daniel Leigh gave us an eye-opening three-page paper, buried in a 250-page World Economic Outlook release last week (http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf). They studied an economic concept called the fiscal multiplier, which is usually defined as the change in real GDP that is produced by a shift in fiscal policy equal to 1% of GDP. In…

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Jeff Little

Nov. 8, 2012, 8:09 p.m.

I agree with the articles sentiment that economics is complex and if you don’t like the answers you can move on to the next commentator, but I am dissatisfied with the untangling of the various positions.

The first rule in math is always keep track of your units and work with good categories.  “Though shalt not mix apples and oranges!”  The classic example of this is when an economist talks about the savings rate with the implication that it represents future potential consumption.  When you realize that the fastest way to increase the savings rate is to move dollars from hands that would spend it immediately to hands that would never spend it in a million years on consumer goods, you realize that using the same term for savings rate outside the radius of consumption and savings rate within the radius of consumption is a category mistake and predictions made based on modeling one of the two will often have the opposite sign if you apply it to the other.

Similarly, the multiplier for tax cuts or increases is a bad category.  Progressive tax changes and regressive tax changes will have drastically different economic effects and the closer interest rates are to zero, the bigger the difference between those multipliers will be.  In fact, if you look at another time like today, when interest rates were stuck near 0 and we were depressed by “capacity gluts” and reactions to that, we somehow found the political will to increase the top tax rate by 150% in what surely had to be the most progressive tax increase in history.  This was the US in 1932 and the result was a change from double digit shrinkage to double digit GDP growth within a span of about 18 months.

The multiplier on tax cuts is plainly and simply a meaningless term based on a category error assuming that tax cuts against capital dollars will have the same effect as tax cuts against consumption dollars.  The next time someone tries to sell you on a study that purports to find this elusive number, kindly remind the person that the average American is about 4 days pregnant.  Unfortunately that probably means it’s a bit too late to put granddad on the pill.

But if you want to know how to fix things, then a good place to start would be with the Great Moderation.  Our last year of > 5% growth was 1984.  Before 1970 we had 5% plus years all the time, but starting around 1980, growth dropped by about a third.  This was the same time that National trade deficits started to rocket upward, incarceration rates jumped, and that national debt reversed its long drop as a percentage of GDP from 125% in 1945 to 30% in 1980.  If you simply reverse what happened at that point, then you should be on a great track to start fixing all these problems.

The reasons for a lot of this should be obvious, but it is worth talking about the connection between distribution of wealth and trade deficits.  Recall that when the number of dollars aiming at tacos goes down and the number of dollars aiming at taco bells goes up, the only possible result is a decrease in ROI.  A similar trend happens in the bond market, which is why in an environment like we have had since 1980 where stock and bond returns have been driven largely by monetary expansion targeted specifically targeted at capital dollars, we have seen heavy correlation, whereas in a lower P/E environment driven more by fundamentals like we had in the new deal era (1933 - 1960) stocks and bonds were inversely correlated.  Anyway, with rapid capital inflation and slow to negative consumer inflation, we had capital bubbles form in the US.  Money flowing into these capital bubbles kept the dollar strong, and put us at a strong export disadvantage as part of an ironic currency manipulation against ourselves.  Or to put it another way, money flowing in to participate in capital bubbles must be matched by money flowing out to purchase goods as part of basic equilibrium theory for supply and demand of currencies.

Anyway, back to point, the heavy similarities between US today and US in 1932 should be a huge source of optimism for those people trying to push a renewal of New Deal policies.  To understand the math behind this, we must start creating economic categories with homogeneous impacts lest we misread our math and put granddad on the pill, so to speak.  The most fundamental place to start is a dollar you put in the hands of a poor person will behave differently than a dollar you put in the hands of a rich person, and understanding this must be a litmus test for putting faith in an economists models and predictions.

Ronald Nimmo

Nov. 1, 2012, 11:08 a.m.

It seems to me that this paragraph states that it is valid to count Government spending twice in the equation GDP = C + I + G + Net Exports.
Counting it as G and also as apart of C seems like double counting to me. This kind of redundancy would seem to undermine the accuracy of the equation.

“Those who argue that reducing spending will also have an effect are equally correct. Government has been a large contributor to consumer income and therefore personal consumption, part of the “C” in the above equation (along with business consumption). The chart below, produced by Bridgewater last April, shows the additional effect of government spending on disposable income for the US consumer. Notice that without government support, disposable income would now be significantly lower”

Brian Gladish

Oct. 24, 2012, 9:32 a.m.

When the “G” in the GDP equation is taken unquestioningly as positive economic activity, we are in a keynesian fantasy that promotes the welfare/warfare state a a wealth-creating engine.  I’m not buying it.

http://radicalliberal.blogspot.com/2010/06/gdp-fixation-every-friday-i-receive.html

Dallas Kennedy

Oct. 24, 2012, 5:52 a.m.

A thoughtful piece, but I must dispute the Keynesian framework. The GDP identity is an accounting truism, but it doesn’t get at all to the sources of economic growth. At best, it gives you a snapshot of current spending. Consumption, investment, and government are paid for from current production. If the current production isn’t big enough, the difference must be borrowed. Certainly, in the near term (over months or quarters), the “fiscal cliff” will impose a recession on the US economy.

But the longer-term picture is shaped by investment and potential return. That in turn is shaped by demographics, technology, and the tax and regulatory environment.

What has many confused is the obsolete way of looking at the US economy as a quasi-closed system, which is natural in the Keynesian framework. Better to think of the “US dollar universe,” which consists of the US, much of the world’s financial system, the commodity markets, and parts of the developing world’s economy (at least that part that is export-oriented). This is the result of “globalization”—“dollarization,” really. Certain parts of that system run permanent surpluses and do the saving; other parts run permanent deficits and do the excess consuming.

But, Congress’ laws don’t directly govern those parts of the US dollar universe outside the US. If they did, the whole problem would make sense and might even have a solution. But they don’t; the “dollarization” of the world’s economy (forcing the rest of the world to recycle, not our surpluses, but our deficits) is a result of Fed policy. The Fed is a pseudo-fourth branch of government and has transformed the situation so as to make much of our traditional political conceptions irrelevant.

Denis Smalley

Oct. 24, 2012, 3:29 a.m.

John’s analysis of the GDP constituents is correct. Unfortunately, the analysis of the derivatives of the GDP such as the “multiplier” are all over the map (as John points out). Big business supporters often whine about corporate taxes and claim they should be free to “create wealth” without government interference. This mistaken line of thinking is captured in Krista G. statement as follows:

“The truth is that government spending must come from somewhere since the government cannot create wealth on it’s own.  Government must take resources from the private sector in order to spend them.  Now, how can that be efficient?  Can the government really spend resources more efficiently than the private enterprise that created those resources?  Impossible!”

I argue this notion is rhetorical and it flies in the face of logical thinking. Wealth in its simplest definition is simply the collection of assets and assets can be created by the government as easily as the private sector (actually, more easily). Thus, the government can certainly “create wealth” just as private enterprise can. The government makes, through legislation and executive powers, regulations that often favor one group engaged in business over another. This effectively shifts assets or “creates wealth” just as as efficiently as private industry does. Private industry loves this when the governmental acts favor their accumulation of assets but whine and gnash their teeth when it does not. The government, in fact, owns (controls) most of the “resources” that exist as in the land, minerals, air space, etc. and they grand private enterprise the right to use, extract, or operate within those resources, provided the tax is paid to do so. To think otherwise is to misunderstand the modern concepts of “land ownership”, “estates”, and taxation.

The roles of Government includes allowing everyone (including business) to enjoy the resources that exist in a relatively equal manner. An example is the water resources that exist in the US. Should not anyone who wants to use this resource be allowed to do so so long as they do not taint the resource for others? But private industry would love to seize this resource and “generate wealth” by selling the rights to its use. That is clearly not in the general public’s interest. The left’s view is that healthcare, retirement security, and care for the poor should be managed more like water resources and that individuals have a right to these things. The right’s view is that business should be free to “create wealth” for certain individuals at the expense of the general public, that being individuals and that they should not be excessively taxed to furnish healthcare, retirement security, or care for the poor but instead, the middle class should shoulder this burden. 

I would agree that government should not compete with private business and in fact, other than regulating business to reduce it’s tendency to rape Mother Earth and all its inhabitants, government’s role in business should be minimal. But I also argue that business should be taxed more than individuals as the government provides many resources that businesses enjoy the benefit of and use to generate wealth for a much smaller population than the general populous.

aemaher@bigpond.net.au

Oct. 23, 2012, 9:20 p.m.

Is it correct to assume that when the ‘Fiscal Multiplier’ has exceeded 1.0 then using the GDP equation it is fair to assume C and I have become dependant on some component of the G? Because in essence this equation is no longer linear. Extending that thought out, is there not a multiplier that could be given for I and C on GDP at different points in the economic cycle?

Daniel Kennedy 94695649

Oct. 23, 2012, 6:04 p.m.

Clearly it is possible to significantly reduce the cost of compliance with government without either cutting spending or raising taxes. Just one example – it is estimated that the cost of compliance with federal income tax law is approximately $400B a year. I suspect a moderately rational income tax law could cut that at least in half and a truly simplified tax law could cut it by say $300B a year – not too shabby an annual stimulus.

In general the only real purpose of any bureaucracy is to grow. It’s immaterial whether the bureaucracy is in the private or public sector - its only purpose is to grow. Fortunately, the private sector has a pruning mechanism. Unfortunately, the public sector doesn’t. Every page, every sentence, every word of legislation and regulation is fertilizer that enables bureaucrats to grow the bureaucracy and the power of the state. Similarly, so does increasing the population of those dependent on the state.

Currently public sector bureaucrats are punished for efficiency and problem solving - they lose funding and therefore status and power. For a sample from an endless list of examples ask yourself:
• Why, as the end of a fiscal year approaches, does every government bureaucracy rush to spend every remaining cent of funds?
• What would happen to the Drug Enforcement Agency if the drug problem were “solved”?
• Why is there a Bureau of Indian Affairs in the 21st century and why have American Indians still not assimilated?
• Why is American education poorer but vastly more expensive today than before the creation of the Department of Education?
• What has the Department of Energy accomplished re energy independence?
• What has the Environmental Protection Agency accomplished other than insuring “dirty” jobs and processes move to such ecological wonderlands as China, India, Bangladesh, etc.?

How does one incentivize government bureaucrats to not accumulate of power?

Girish Vinod

Oct. 23, 2012, 3:20 p.m.

I would like to know what effect rise in gas and oil production would have on deficit reduction as that will drive growth and industry turning into net exporter instead of importer of this resource.

Gary Levin 30989

Oct. 23, 2012, 12:19 p.m.

John- as always, love your articles, this one in particular. Great summary of the issues. The health care law-the PPACA - will reduce Medicare spending to providers by 716 Billion over 10 years or about 14% per year (simplified)- this is the official CBO estimate. Ryan’s plan proposes the exact same amount via a different route. Either way it will reduce spending albeit not enough to ‘bend the curve’ of health care spending. The great hope is placed on Accountable CAre Organizations (ACOs) and disease management (DM) yet there are controlled studies for both that clearly demonstrate neither work (financially) adequately!  The CBO just published their 10 year study results for DM and proven that while cose-effective, it does not return an ROI.  ACOs had a 5 year demonstration project, and the data analysis for some of the best medical systems in the country were published in the NEJM which clearly showed ACOs reduced spending ONLY for dual eligibles (medicare-medicaid) and even that was insufficient (1% or less).  Your theme is that budget deficits simply can’t go that high..and neither will medicare spending—because when the final results come in across the country (implementation starts this January), they will fail. The most likely scenario is that the legal and clinical infrastructure the gov’t created through ACOs will enable Medicare to capitate all provider systems, converting medicare from an indemnity plan into a fixed-budget (more predictable) capitated type system. Surely that will fix the growth rate. It may also get the gov’t out of micromanaging health care.  I actually support that capitated type environment and look forward to it.

ralphsf@gmail.com

Oct. 23, 2012, 10:56 a.m.

The problem with all analysis of this kind is that your very basic starting premise is incorrect.  Thus all logical arguments made after that point are good and solid but unfortunately irrelevant.  Problem assumption is that going into a recession would be bad.  They are necessary and beneficial.  They are part of true capitalism free from the machinations of human intervention which always has unintended consequences.

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