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The · Psychohistorian

Understanding the "fiscal cliff"

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If you're confused about the chaotic news reports on the "fiscal cliff", the thing to understand is this: the fiscal cliff isn't about deficits being too big. It's about deficits being too small. And if that confuses you, you've been reading too many articles from journalists who don't understand the concept.

Underlying the idea of the fiscal cliff is this: the economy is still depressed from the recession 3-4 years ago, and the primary goal of policy should still be to help the economy recover. That's the opinion of U.S. Federal Reserve chairman Ben Bernanke, who popularized the idea of the fiscal cliff this past July.

There are two traditional types of policy that can be used to help the economy recover. One is monetary policy, which is under the control of Bernanke, and he has been doing his best by pumping trillions of dollars into the economy. The other is fiscal policy - thus why the cliff is fiscal.

The major schools of fiscal policy are Keynesian economics and supply side economics. Keynesian economics says that if you want to stimulate the economy, you want the deficit to be big - you want taxes to be low, and you want government spending to be high. Supply side economics says, among other things, that if you want to stimulate the economy, you want taxes to be low, while the total amount of government spending doesn't really matter that much - just what that spending is spent on.

The fiscal cliff, then, is the fact that on January 1, 2013, we are going to make a sudden step change in the wrong direction from the standpoint of fiscal stimulation of the economy. Tax rates are going to go up substantially, which is bad from both the Keynesian and the supply side standpoints, and spending will be cut through sequestration, which is also bad from the standpoint of Keynesian economics, and not especially good from the standpoint of supply side economics either.

What Bernanke is saying, in simple terms, is this: until the recovery is complete, we should extend the Bush tax rates, if not cut them further, and we should also keep government spending at current rates, if not increasing them. A corollary is that we should keep the deficit large, again until the recovery is complete.

Of course, there might be some people who believe in neither Keynesian nor supply side economics - for example, they might be deficit hawks who think the government budget should stay in balance, and that the government shouldn't worry about the economy as a whole. These people would presumably argue for going off the cliff - not just if a favorable compromise can't be reached, but as a good thing in and of itself.

Going off the cliff involves an increase in federal tax rates and a decrease in federal spending. There's another name for the strategy of increasing tax rates and decreasing spending: austerity. That has been tried, most notably in Greece. There, tax revenues fell despite increased tax rates, resulting in continued deficits despite reduced spending.

A July article on the fiscal cliff:
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