Peering Over (the Fiscal Cliff)

Copied from a comment I made on a discussion in one of my LinkedIn groups:

The standard Keynesian approach to correcting underemployment is to increase aggregate demand (AD), but how do you do that?  You increase income. How do you increase income?  There’s the issue:  You can either do it (1) with monetary policy (primarily by loosening credit, which is already about as loose as it can get right now), or (2) with fiscal policy (cut personal income taxes, increase government spending on transfer payments, or increase government spending on _____ program in order to artificially create demand and thereby jobs to meet it), or (3) by facilitating private sector investment to create new jobs by personal & corporate tax cuts, investment and R&D tax credits, and deregulation.  Each has its own pros and cons; the first two tend to be more inflationary, while the last is distasteful to some because of the perception that its most direct impact is on the wealthy, and due to the fact that folks tend to prefer immediate gratification over long-term growth (as evidenced by the abysmal rate at which we put income into savings in this country). 

What we’re facing now is that large sums of government expenditures have gone into, mostly, #2, to little effect, with the result that expenditures are growing faster than revenue at a much faster rate than in the past.  I would argue in fact that this mounting debt is to some degree why we have seen so little effect from the past few rounds of stimulus.  

The issue is that government debt, which is financed through bonds, competes in the same market as corporate debt, which is what finances the kind of capital investment that contributes to future productivity.  This leads to varying degrees of “crowding out”, where investors opt for safer Treasury bonds over riskier corporate bonds, requiring corporations to pay higher yields to draw investors, which increases the cost of acquiring new capital, and ultimately retards future productivity.  So, I suspect one reason for the sluggish recovery is that we are seeing the impact of depressed capital investment over the past several years; therefore, there is less productive capacity and less job creation.  I haven’t done any modeling to support this, but based on the theory, it is what I predict to be true. 

So, the fiscal cliff comes about because, in a rare moment of clarity, lawmakers apparently realized that the continued expansion of government debt, which now exceeds our annual GDP, cannot continue indefinitely, and perhaps they even realized that the pool of potential creditors is shrinking, given the sums required to continue our fiscal expansion.  I do think that if we do “go over” the cliff the results won’t be cataclysmic.  I suspect we probably would go back into recession, mainly because households will see a noticeable impact on their after-tax income, which will be painful to a lot of folks.  But it won’t be a depression, and I suspect it won’t be as deep a recession as what we just came out of.  In the long-term, it might just focus enough attention on the fiscal situation to get some actual reforms in place.  (Focusing event... Kingdon... any of my policy people?)  Or the preference for immediate gratification might continue to prevail.