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Thoughts from the Frontline

The Perils of the Fiscal Cliff

October 23, 2012

Choose your language

“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 ( 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 ( 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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Gordon Davis Jr

Oct. 23, 2012, 8:06 a.m.

I will be more than a little surprised if Washington comes to its senses and does the right thing regarding the economy.  Both sides have staked out positions that would have disasterous consequences.  Any compromise is likely to be so watered down as to have little benefit.  My guess is that little will be done to curb deficits and we will all get to experience the result.  There will be much finger pointing and feigned surprise, and of course by then it will be too late.  Politics is an enterprise unto itself.  It is inwardly focused to the point that even the economic decay of our nation is ignored.

Robert Davies

Oct. 23, 2012, 7:07 a.m.

Thank you. Even by your standards, this piece is insightful, clear, concise and well-articulated. Further, the comments posted (at least at this time) are articulate and intelligent. Certain of these fora, unfortunately, degenerate into nonsense.

Krista Gifford

Oct. 23, 2012, 6:34 a.m.

The idea that government spending increases economic growth is seriously mistaken.  The history of the GDP statistic is such that it was created NOT to measure economic growth or total output.  The precursor to GDP was created in the 30s as a way to measure how the government could have an impact on the economy.  As such, of course GDP rises when government spending increases!  That was the whole point of the statistic.  What it does not mean is that economic growth is created via government spending!  GDP is much more a measure of spending than of economic output!  If government spending was such a help to economic growth then why isn’t Greece growing like crazy?  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!  Thus, the larger government spending is, the more resources are taken from the productive sector and spent in the unproductive sector.  That lowers overall output - even as we don’t see it in the GDP statistic.  Cutting government spending is actually STIMULATIVE to the economy because it removes the thief who is taking resources from those who best know how to use them.  And if you look at the statistics from countries around the globe, that is just what you see.  The lower government spending is, the more productive the economy gets (assuming rule of law is enforced.)

Oct. 23, 2012, 5:57 a.m.

John, I have a couple of thoughts on the multiplier question.  Some reputable economic studies have found that the multiplier for taxes is larger than the multiplier for spending, which means that spending cuts are a more efficient form of austerity than tax increases.  Europe’s ‘austerity’ emphasizes tax increases, which is rather like flogging a dead horse. 
In the US, the practice of referring to a ‘baseline’ budget leads to referring to slowing the increase in the planned growth rate of an expenditure as a spending ‘cut’, which it is not.  Actual spending cuts will be required, and Americans have, IMO, been corrupted by transfer payments to the point that they can no longer face the reality of budget cuts.
In another vein, I suggest that the G multiplier is not a fixed number, but a step function that is related to the level of government’s share of GDP.  At very low levels of government spending, such as those prevailing at the beginning of the 20th century, the spending multiplier may have been above 1.  And most people now understand that a full socialist economy may have negative multipliers.  As government spending grows, as a percentage of GDP, I propose that the spending multiplier declines, while the taxing multiplier rises.  In other words, the private economy, which has to carry the deadweight load of government, increasingly loses vitality as government grows.  If this is actually the case, only shrinking government will restore growth in the private economy.  IMO, Americans have to choose whether they want permanent low economic growth, and a crony capitalist society where one’s economic prospects depend on knowing the ‘right’ people, or a higher growth system with plenty of job opportunities but fewer ‘free’ government benefits.  Unfortunately, it seems to me, that most Americans have forgotten, or never been taught, the origins of our Constitution and the theory behind it, making them ill-equipped to make an informed choice.

Ski Milburn

Oct. 23, 2012, 5:37 a.m.

Another factor that might be pushing the Multiplier into unwelcome territory is wealth and income inequality, which has expanded in the US from First World to near-Third World levels over the last 30 years.  For example, when we read that virtually all of the income gains of the last decades have gone to the very top, the middle class has flat-lined in real terms, and the “47 percent” has lost ground, it shouldn’t surprise us that neither stimulus nor austerity seems to be having the expected result.  It’s like an airplane that has stalled and is entering a spin and the response to control inputs has reversed.

pawel kowalski

Oct. 23, 2012, 5:14 a.m.

Intresting paper by R.Prechter”

Social Mood, Stock Market Performance and U.S. Presidential Elections: A Socionomic Perspective on Voting Results

We analyze all U.S. presidential election bids. We find a positive, significant relationship between the incumbent’s vote margin and the prior net percentage change in the stock market. This relationship does not extend to the incumbent’s party when the incumbent does not run for re-election. We find no significant relationships between the incumbent’s vote margin and inflation or unemployment. GDP is a significant predictor of the incumbent’s popular vote margin in simple regression but is rendered insignificant when combined with the stock market in multiple regression. Hypotheses of economic voting fail to account for the findings. The results are consistent with socionomic voting theory, which includes the hypotheses that (1) social mood as reflected by the stock market is a more powerful regulator of re-election outcomes than economic variables such as GDP, inflation and unemployment and (2) voters unconsciously credit or blame the leader for their mood.

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