Federal Reserve Chairman Ben S. Bernanke, taking questions during a February House hearing on monetary policy, uttered two very special words: fiscal cliff.
“Under current law, on January 1, 2013,” Bernanke said, “there's going to be a massive fiscal cliff of large spending cuts and tax increases.”
It was the first time the phrase had been used, but the idea behind it was far from news. Well before Bernanke testified, the Bush-era tax cuts and the recovery stimulus were scheduled to sunset, and the sequester was set to take effect. Nor was Bernanke's coinage particularly apt, as it likened an accumulation of fiscal policy decisions to a geological phenomenon, a gradual austerity to a sudden apocalyptic plummet.
Still, it stuck. The vivid imagery and false urgency of the term transformed budget arcana into a national Wile E. Coyote moment. The words lent themselves to media overexposure and political opportunism. Despite efforts by Chris Hayes, Ezra Klein and Suzy Khimm to rebrand it the “fiscal curb” or “austerity crisis” -- either of which would be more consistent with reality -- Bernanke's original phrasing has held fast. (Disclosure: I am also a writer for Klein's Wonkbook newsletter.)
Whatever Bernanke's intention in February, Congress now works in fear of falling off his fiscal cliff. The irony is that while economic recovery rests largely in Bernanke's hands, the tyranny of impending austerity is leading Congress toward poor decisions about the long-term structure of public spending and tax policy. These are mistakes monetary policy could never offset.
The cause of our cliff problem rests in the commingling of responsibility between fiscal and monetary policy in managing the economic recovery. A more mature way of doing business would charge the Fed with stabilizing demand in the short run and Congress with a structural environment conducive to the social welfare and economic growth over the long run. The U.S. is doing neither well right now.
Neither institution, however, can achieve such ends without the cooperation of the other. Congress, with good reason, does not want to send the economy spiraling back into recession; yet to put in place any spending curbs in the coming years will require a monetary commitment to recovery. The Fed, with good reason, would like to re-establish a normal policy regime and leave the bond-buying business -- but it won’t do that knowing that Congress is about to implement one of the biggest austerity packages in modern economic history.
Meanwhile, what matters -- a real need for proper long-term arrangements of public finance -- is lost in the consideration of short-term political ends and the fear of blame for economic contraction.
If Congress does not act, what is coming is $500 billion in net deficit reduction in the next year -- four-fifths in tax hikes, one-fifth in spending cuts -- and $7.1 trillion over the next decade. Of that $7.1 trillion, $4.8 trillion would be in increased revenue from higher tax rates on income, estates and payrolls. The other $2.3 trillion is in spending cuts to defense, Medicare and discretionary spending. Though it will not mean immediate disaster, the fiscal cliff would probably result in a recession and the return of 9 percent unemployment, according to a broad consensus of economic forecasts.
The best response is incremental-but-accelerating austerity consistent with a recovery. Such a mix of fiscal and monetary policies would support growth while putting the structural deficit on a clear path to elimination.
A reasonable solution might be a combination of spending cuts and revenue increases which stabilizes both at 18 or 19 percent of gross domestic product. That would be in line with their 50-year historical average. Increases or decreases beyond this level demand larger arguments about the proper size and role of government.
Alternatively, one could contend that demographic shifts -- namely, the growing elderly fraction of the population -- or rising health care costs justify greater public resources without any moral claims about government’s proper size. There is merit to this argument, but it neglects the revenue side of the historical consensus on the taxes paid to the federal government.
Maintaining the long-term status quo will nevertheless mean substantial increases in tax revenue. At 17 percent of GDP, federal revenue is structurally too low to support public spending at its historical average, let alone what might be required given aging and health costs. Depending on the extent to which tax deductions are curtailed, there is a good chance statutory tax rates must rise to achieve a reasonable revenue goal.
Monetary policy can help. A stronger recovery would increase tax revenue as nominal income rises, thereby reducing the cyclical component of the fiscal deficit. The latest Fed minutes -- which talk of numerical thresholds and goals for inflation and unemployment before interest rates rise -- suggest we're moving in that direction.
Long-term deficit reduction will also require substantial cuts to planned public spending, whether one assumes a return to the historical revenue average or something slightly higher than that to account for demographic change and health costs. This is particularly true beyond the budgetary “out-years,” or 20 to 30 years from now. At that point, federal promises on Medicare and Medicaid become unsustainable without large increases in tax revenue which raise fully a quarter of GDP. There is no reasonable scenario for sustainable public finances without deep rollbacks of spending promises beyond the out-years.
The austerity the fiscal cliff would achieve in one fell swoop would best be done gradually. Such an approach would be more in line with the real danger in our public finances, the combination of structurally low federal revenue and long-term increases in planned spending.
Any such plan will take time to negotiate and put into motion. And it will take the proper monetary policy to give fiscal policy independence from the job of short-term economic stabilization. But if the U.S. is to maintain its long-standing consensus around revenue and spending, the “fiscal cliff” gives it few other choices.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)
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