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.


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.