Perils Of The Fiscal Cliff--John Mauldin

By: John Mauldin, Millennium Wave Advisors / GoldSeek.com

The Problem with Austerity
The Perils of the Fiscal Cliff
If Something Can’t Happen…
GDP = C + I + G + Net Exports
Economic Indicators for the Election – It’s the Economy, Stupid!
Brazil, Uruguay, Argentina, Chicago, New York, and North Dakota

“Spain is not Greece” – Elena Salgado, Spanish Finance Minister, February 2010

“Portugal is not Greece” – The Economist, April 2010

“Greece is not Ireland” – George Papaconstantinou, Greek Finance Minister, November 2010

“Spain is neither Ireland nor Portugal” – Elena Salgado, Spanish Finance Minister, Nov. 2010

“Ireland is not in ‘Greek Territory’” – Irish Finance Minister Brian Lenihan, November 2010

“Neither Spain nor Portugal is Ireland” – Angel Gurria, Secretary-General OECD, Nov. 2010

“Italy is not Spain” – Ed Parker, Fitch MD, June 12, 2012

“Spain is not Uganda” – Spanish PM Mariano Rajoy, June 2012

“Uganda does not want to be Spain” – Ugandan foreign minister, June 13, 2012

Having been to all the countries listed above, with the exception of Uganda (although I have been to 15 countries in Africa, several bordering Uganda), I am most happy to confirm that they are all different. Just as you would grant me the fact that the US is not the UK and that France is not Argentina. To paraphrase Tolstoy, dysfunctional countries come by their unhappy sets of circumstances in their own individual ways.

How does one go about comparing the financial crisis in one country to that of another? The International Monetary Fund tried to do just that, setting off a rather torrid debate in economic circles. And while we will look today at their analysis, the upshot is that the economic models used to guide monetary and fiscal policy may not be working as they did in the past. Last week in this letter, I postulated a condition I called the Economic Singularity. Just as the singularity at the center of a black hole creates a region where mathematical models break down, a large mass of debt will create its own Economic Singularity where economic models no longer work as expected.

Given that within a few weeks a very large debate will erupt in Congress about how to deal with the “Fiscal Cliff,” with both sides displaying economic models that demonstrate the clear superiority of their chosen solutions and the utter disaster that will ensue if the opposition’s plans are enacted, I think we will find it useful to look at some of the underlying assumptions. Given the fact that almost everyone, including your humble analyst, has concluded that if the tax increases and spending cuts were to be enacted as the legislation currently dictates, a rather serious recession would follow in short order, it might help us to look at some of the assumptions behind that assessment.

In today’s letter we’ll peek over the Fiscal Cliff and see what economic models can tell us about government spending. And if we have time we’ll quickly look at an interesting study that uses economics to predict the outcome of this US presidential election.

At Mauldin Economics we have a laser-like focus on estimating what the economic climate will be in the coming year. As a bit of a preannouncement, I’ll be doing a Post-Election Summit Conference on November 20 with a few of my friends, looking at the likely direction of the economy with the certainty of the presidential and congressional elections behind us. It will be a free seminar, cosponsored by my friends at Real Clear Politics (www.realclearpolitics.com) and available on the Internet to those who register. I’ll give you more details as we get closer, but this is something you won’t want to miss. And now let’s hang our toes out over that Fiscal Cliff.

The Problem with Austerity

The chief economist for the International Monetary Fund, Olivier Blanchard, and his associate Daniel Leigh gave us an eye-opening three-page paper, buried in a 250-page World Economic Outlook release last week (http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf). They studied an economic concept called the fiscal multiplier, which is usually defined as the change in real GDP that is produced by a shift in fiscal policy equal to 1% of GDP. In simple terms, if the fiscal multiplier is assumed to be 1.0 then a change in government spending by 1% (either an increase or decrease) would produce a corresponding change of 1% of GDP.

Most institutional economists prior to this paper assumed the fiscal multiplier to be about 0.5. Again in simple terms, this would mean that government spending cuts equal to 1% of GDP would reduce actual GDP in the coming year by about 0.5%. The fall in GDP would of course reduce tax revenues, which means that you would have less than a 1% actual cut in the deficit. If the tax rate is 30% in this example, the deficit will be reduced by only 0.85%. That may be an acceptable outcome when an economy is growing nicely or the deficit and total debt are too high and the bond market is forcing the government to cut back.

While Blanchard and Leigh agree that in the past the fiscal multiplier was generally about 0.5%, they suggest that in the recent fiscal crisis the fiscal multiplier has been much higher. Their study suggests that it has been at least 0.9% and perhaps as much as 1.7%. This certainly seems to be the case in Greece and Spain, as their austerity measures appear to be working in reverse.

Gavyn Davies of the Financial Times views the IMF research finding from the perspective of England, where the government is taking 40%. The results are less than pleasing:

“If, however, the multiplier is 1.7, then the same initial public spending cut of 1 per cent of GDP would reduce real output by 1.7 per cent. The second round effects of this reduction in output would reduce tax or raise transfers by 0.68 per cent. The net overall improvement in the budget deficit would therefore be only 0.32 per cent. The economy would be in recession, and the budget deficit would hardly improve at all. Even if this were acceptable to governments, it would not be acceptable for very long to their electorates.

“This pessimistic arithmetic is not that far away from describing what has actually happened in some countries, like the UK, in the past two years. Furthermore, if we take this arithmetic as a given, there is more bad news to come. The major four advanced economies are now all planning to tighten fiscal policy in the years ahead by an average of 1 per cent of GDP per annum.

“…With a fiscal multiplier anywhere near the upper end of the Blanchard/Leigh suggested range, the effects of these policy changes would eliminate any chance of a rebound to normal growth rates in the advanced economies for some time to come. Interestingly, the planned fiscal tightening in the troubled economies of the eurozone is no longer any greater than it is for the major economies, because of the recent relaxation of some budget targets. Even so, it is hard to see how these plans could be sustained if the fiscal multiplier is at the upper end of the possible range.”

But there is a problem with this analysis, as Davies and others point out. It assumes that the results in one country will pretty closely match those in any other country. However, if you take out Greece and Germany, as an example, you pretty much remove the increase in the fiscal multiplier. Not that that would stop Paul Krugman and his fellow Keynesians from trumpeting this analysis as a reason to eschew all forms of austerity. In any case, the research does call attention to the dangers of creating economic models that are used to guide public policy. Davies continues:

“…The decline [in the IMF model of the fiscal multiplier] occurred mainly because economists became much more aware of the need to make assumptions about monetary policy when making the estimates. If the central bank is assumed to hold monetary growth or inflation at a given target rate when fiscal policy is tightened, then interest rates will decline and this will offset some of the negative effects of the fiscal change on output. The multiplier will be lower.

“The opposite is also true. Now that interest rates are stuck at the zero lower bound, central banks cannot reduce policy rates when fiscal policy is tightened, and the multiplier is correspondingly increased.” (emphasis mine)

continue at Gold Seek: