Reading the tea leaves on financial markets and fiscal austerity
By now, it’s (finally) becoming well-recognized that the term “fiscal cliff” confuses more than it clarifies. The worst problem with it is that it presents the sharp fiscal contraction baked into current law for 2013 as a single monolith, when in fact it’s the result of a bunch of separable tax increases and spending cuts. Given that our previous effort at renaming the “cliff” clearly failed, I now officially nominate “à la carte austerity” as a new entry.
A second problem with the “cliff” metaphor is that it carries the strong implication that if this à la carte austerity is not solved by Jan. 1, then economic chaos will ensue. This is clearly wrong. If nothing is done to address the fiscal contraction throughout the entire first half of next year, then yes, the economy will re-enter recession. But we will not be slammed back into recession Jan. 2 if this isn’t solved by then. I should note one important caveat to this: fiscal austerity will be very “cliffy” indeed for about two million of the most vulnerable Americans, as extended unemployment benefits will see a hard cutoff by the end of December. So if policymakers are trying to manage this situation with maximum efficiency and compassion, it seems that extending the longer unemployment benefits is an obvious place to start, even if other elements of the à la carte austerity are not solved. Yes, I’m not holding my breath either.
Every now and then, those interested in maximizing the hype of the “cliff” in order to push their favored fiscal policies will try to push back on the “not a cliff” evidence-mongering being done around the issue. They like to claim that while the fiscal contraction is not “cliff-like” in its primary Keynesian effect of putting a slow leak in the economy’s spending power as taxes rise and public spending falls, it will be made “cliff-like” because of (cue ominous music) the “Response of Financial Markets.”
Is this totally off-base? Maybe not, but it’s important to understand why.
First, the normal specter invoked regarding financial market punishment for fiscal policymaking sins is that bond market participants worried about excessive long-run debt will push interest rates on public debt higher—the now-famous “bond market vigilantes.” And the bond-market vigilantes have indeed been predictably invoked in recent fiscal cliff debates. So do we really have to worry about interest rates on government debt spiking as a result of our long-run debt problem? Nope. Long-term interest rates on U.S government debt are still near historic lows, and contrary to much talk, this is not some lucky fluke that can turn on a dime. Instead, these interest rates are low for the same reason that budget deficits are high: the economy remains very weak, with desired spending lagging available savings. And if these interest rates begin to creep up if policymakers actually did something useful and spurred economic activity through fiscal stimulus, this would not be a sign of policy overreach and looming disaster. Instead, it would be a sign that stimulus had worked, and that enough spending had been generated to move the economy close to potential.
Lastly, we should note how odd it is to invoke the specter of bond-market vigilantes punishing us for failing to solve the “fiscal cliff/à la carte austerity.” Remember, the problem posed by the “cliff/austerity” is that budget deficits will fall too fast next year. This fall in budget deficits means that spending power will leak out of the economy and push the unemployment rate up. But bond-market vigilantes are supposed to like lower budget deficits, right? So, why would they punish us for failing to keep budget deficits higher? If you answered “because like all boogeymen, the bond-market vigilantes are mostly fake and are invoked only to coerce behavioral changes agreeable to the elite,” give yourself an A.
So, if we shouldn’t be worried about the bond-market vigilantes punishing us for, um, doing exactly what they allegedly want us to do, why is the specter of financial market crises making the coming year more fiscally “cliffy” not totally crazy?
Because, as we approach Jan. 1 (and then move beyond it) with no solution in place, the stock market will indeed begin signaling trouble. This signal will likely be both downward movement and increased volatility. Normally, anybody who confidently tells you what the stock market is going to do in the near-term should be ignored, as predicting these short-term movements is a fool’s game (if it wasn’t, there’d be a lot more millionaires in the world). But in this case, there would be very solid reasons for a stock-market decline if we move into the new year with no resolution to the à la carte austerity—economic growth will fall (or even begin contracting), and this will squeeze profits. Given that the value of the stock market is largely dependent on observers’ best guess as to future profits, these expected profits for 2013 will clearly be lower if we fail to do anything about the à la carte austerity.
To be clear, those hoping to use the concrete and very real short-run fiscal problem of too-small deficits in 2013 as leverage to force policymakers into adopting their own pet solutions for how to solve the far-off and theoretical danger of too-large deficits projected decades from now, will pounce on any stock-market decline (especially if it comes in the form of spectacular, nerve-jangling one-day selloffs) to claim that financial markets are telling us we need the vaunted “grand bargain.”
This is nonsense. A stock market decline—either slowly or in spectacular freak-outs—will just be telling us what we already know should happen and what is easy to do. Congress and the president should solve the problem of slow recovery once and for all by injecting more fiscal support into the economy in the next couple of years. And this can be done without any grand bargain—and should be done without any grand bargain that relents on moving tax rates higher on high incomes or that slashes social insurance programs’ benefits.