Thursday, October 25, 2012

Cliff Hanger

I mentioned in a post awhile back about writing a post concerning the spending side of the so-called Fiscal Cliff we are approaching. This is that post. Promise kept.

Don’t expect that same kind of responsiveness from Washington regardless of who wins the election. My expectation is that Rombama will deliver as much and as little as it takes to lie with a straight face that, "In the face of an epic challenge, the American people came together to forged a grand compromise. While this solution does not match the ideal of any one party or interest group, it does satisfy many of those goals and all of our greatest needs…." Disaster avoided, I am your savior. Or something to that political effect.

The spending side of the equation, forced spending cuts disproportionately affecting the Defense Department (because that is where the discretionary money is), is arguably the less concerning part of the equation. This is especially so in the long run. The short run effects of sequestration can be mostly if not entirely offset through proper monetary policy. The monetary authority must change expectations to demonstrate a willingness to accommodate any fiscal reduction. The political will for this is weaker than it should be, but it probably is strong enough and will strengthen in the put up or shut up point of fiscal cliff diving. The added bonus would be that monetary policy arguably has much less distortionary effects than does fiscal policy—the former says demand increases somewhere and the market guides the where, the latter says demand increases through government. Unfortunately, I don't think this will happen as I don't think we will fall off the spending fiscal cliff.

The tax side of the fiscal cliff remains the more imposing part and has the more important long-run considerations. The uncertainty alone is a source of reduced economic growth. I'm cautiously optimistic about the chances for tax simplification and otherwise meaningful reform. I'm more optimistic about tax rates and incidence not being as severe as a full plunge over the cliff would be. Here I think there will be a decent compromise, but most of the benefits will be in terms of certainty rather than good policy--we'll at least know how badly taxation will be moving forward.

Back to the spending, I am very pessimistic about the chances of substantial spending reform or reduction. That means the fiscal cliff is avoided from the spending side—we don't get the big cuts, hence we don't fall off the cliff with the associated risks to short-term growth. But the manner in which we avoid the cliff is in no way a sustainable path to fiscal prudence. For evidence supporting my view on spending and the compromise to come, look at how Obama defines a "grand bargain".