In-depth analysis on Credit Writedowns Pro.

The US election and the fiscal cliff

The election is now over and it’s time to think about what is to come. The most pressing political concern is the so-called fiscal cliff that has resulted from a budget deal Washington’s politicians cobbled together to avoid default during the first debt ceiling debacle. I believe the fiscal cliff is genuinely something to worry about. And I will be debating the issue on RT’s crosstalk tomorrow on television. Here’s the background to what I want to say.

There is no solvency contraint for the United States government because it pays for things in IOUs it manufactures with computer keystrokes. So, the debt ceiling crisis in the US was a ‘manufactured crisis’ to prevent the US from continued large deficit spending. The opposition to deficit spending is in part due to the misplaced discomfort people have in seeing government ‘live beyond its means’ by spending more than it ‘earns’ despite the fact that no solvency constraint exists. There is no getting around this. I believe this discomfort will always exist. But a large part of the opposition to these huge deficits is ideological because deficit spending often implies big government, something considered antithetical by many to the notion that only limited government is synonymous with liberty. In short, the debt ceiling crisis and the looming fiscal cliff, which is an out growth of that crisis, are firmly rooted in an ideological debate about the size and role of government during a time of an economic, non-military crisis.  

At the time of the debt ceiling debates in 2011, the thinking in policy circles was that Washington could avert a voluntary default by compromising through lifting the debt ceiling and simultaneously setting up a draconian and unpalatable set of automatic spending cuts that would need to be tackled later. Think of it as kicking the can down the road a bit by creating a doomsday scenario which rational people would look to avert by any means necessary. The problem of course is that these things have a way of spiralling out of control as political considerations trump rational economic objectives. That’s why I believe the fiscal cliff is an economic threat.

Here are three things to consider:

  1. Wasteful spending is always wasteful irrespective of the size of the deficit. Wasteful government spending (aka malinvestment) should always be eliminated irrespective of the size of the federal deficit. There is no reason to target deficit reduction in order to decrease wasteful government spending unless one believes that only this manufactured rationale can result in eliminating government waste.
  2. Government deficits translate into non-government surpluses. When the government runs a deficit, the non-government sector runs a surplus of equal size. That means the government deficit equals the combined surplus of the private sector and external capital account.  To reduce the government deficit in any period, the private and capital balances must increase in aggregate by the exact same amount in that period. See here for more on this issue using the euro zone.
  3. The US deficit ballooned after the US subprime crisis. In my view the cause and effect here are obvious. A crisis that created private sector debt distress induced a retrenchment in the private sector. Households and businesses increased net savings  and so government deficits increased in equal measure. The private debt problem is a balance sheet and cash flow issue. If people’s primary asset, a house, declines in value and they still have just as much debt, their balance sheet starts to look worse. If a household family member loses a job and that household has mortgage payments to make, they have less income to support the debt payments. What people do when this occurs is either default or cut back in order not to default. The root cause of the government deficits then are to be found in private sector debt distress.

What these three things tell me is that recession is what results from trying to reduce government deficits when the root cause of the deficits lie in private sector debt distress. When the government raises taxes or cuts spending in that situation, the result is less income in the private sector. And to the degree debt distress still exists, the result of less income is less spending and private defaults, also known as recession and credit writedowns. The larger the recession and the credit writedowns, the greater the possibility of bank failure, financial panic and debt deflation.

Of course, cutting spending or raising taxes will eventually cut the deficit after the initial negative economic implications. But the economy will have to go through recession before this occurs. And the potential for even larger deficits temporarily due to the large fiscal multiplier during a credit crisis is something the IMF has recently warned about.

Politically, it makes sense for the Republican party in the US to push the deficit issue because it resonates with much of the voting public and their own voter base. This is what I expect. Of all the proposed Fiscal cliff changes, ending the payroll tax cut and starting a series of healthcare tax increases are done deals in my view. This will result in a Fiscal Clifflet at a minimum. Moreover, the Republicans have to know that reducing spending also weakens economic growth, something for which President Obama could be blamed. I believe the Republicans will delve into the fiscal cliff issue with zeal in order to make Obama 2013 like Roosevelt 1937.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

6 Comments

  1. David_Lazarus says:

    You are completely right about the governments deficit is the support for the private surplus. Though I think that the bigger problem is the distribution of that surplus. The private sector surplus is primarily with the corporate sector so the individuals have insufficient surplus to pay down their debts, all while the corporate sector is awash with cash.

  2. Dave Holden says:

    I agree with all of this, particularly the political and human dimension which many seem to ignore.

    Productive use of credit, whether it be government or private sector matters. Prior to the crisis we saw a great deal of non productive use of private credit, in particular speculation on assets. It seems, that through a combination of main stream/influential economists not understanding the endogenous nature of money, and a clever sleight of hand by some conservatives, that a narrative has taken hold along the lines that rather than it being the private sector that had been “living beyond its means”, it was actually the government sector. In fact the parlous state of government finances are not because it was living beyond its means but because of its response to the result of the private sector doing just that.

    That said, the UK has shown that in the first instance this narrative is an easy sell for conservatives – it fits their ideology and a commonly held view about how the economy works.

    The problem is that it appears not to be working, certainly in terms of the ratio debt to GDP. Of course these things are rarely clear-cut and there’s always room for spin and counterfactual, so I’m sure this narrative still has plenty of political legs.

    The bigger picture is however, that there is no easy way out of this crisis, pain is inevitable, the politics and the propaganda are about who does and who doesn’t feel it the most. In this regard it’s definitely 1-0 to the one percenters.

    • David_Lazarus says:

      I have been giving the ratio of debt to GDP some thought. Prior to the crisis most governments had moderate debt levels compared to GDP, usually around 40% of GDP before the crisis. As you said the surge in government debt was a response to bail out the private sector. That fact has been ignored by the UK government in its zeal to dismantle the state. In fact the recent announcement that the UK treasury will be keeping the BoE surpluses to reduce the deficit now. Though it has a nasty sting when they start to pay back that debt. It is another form of financial engineering that created the problem in Greece.

      The problem is that the tax payer around the world has been impaled on the bail out hooks by governments. This will be all that is needed to destroy welfare programs around the world. That will in turn lead to revolts by the 99% unless they can allow it to be a gradual slump in living standards. So while the 1% are doing well now I see significant problems ahead which are not being addressed.

      • Dave Holden says:

        Indeed.

        The problem in my mind comes down to power and vested interest. One of the reasons I’m not an MMTer is that although I think they have a good description of the monetary system I don’t have the same opinion on what kind of policy space that opens up. Governments are about money and power, they work best when the interests of money and power are aligned with the interests of the many. When that isn’t the case tensions will build. In the UK there is a clear policy to distract from the bailout of the 1 percent by pitting the working poor against the unworking poor and sadly that stuff sells. What I find particularly vexing is that in my mind this is all aided by the failure and dysfunction of conventional economics who either pretend their failure to recognise the biggest post war economic crisis didn’t happen or jump through hoops to hang onto clearly broken models.

        • Dave Holden says:

          As an aside, I’ve just seen this review http://rwer.wordpress.com/2012/11/09/best-economics-read-of-2012/. Looks like it might be an interesting read.

        • David_Lazarus says:

          I think that you have identified the problem. All neoclassical economists are trying to hang on to their models to explain what happened. That is why they missed the crisis in the first place and are failing to come up with solutions that explain what needs to be done. It is why they are criticising Obama’s policy for the lack of a recovery. When their policy is to do the worst for the economy by maintaining debts.

          Edward is write about the problem being debt. Until that debt is eliminated the problems will remain. So that means a multi decade stagnation while debts are paid off very slowly because of the impact of the policies make earnings growth an impossibility and then QE is destroying purchasing power to the masses so eventually they will all collapse one by one and as they do their debts will be written off.