Blowing up the fiscal cliff

What will happen if the Republicans and Democrats don’t reach an agreement on the fiscal cliff? According to a recent poll, almost half of Americans think the US budget deficit will rise. Actually, it is the other way around. Without an agreement, mandated spending cuts will be enacted and existing payroll tax cuts will expire; this significant deficit reduction will probably plunge America back into recession. That is why we should have adopted Paul Krugman’s preferred nomenclature and called it the “austerity bomb.”

For that’s what it is: an unnecessary and pernicious explosion that will stun America’s fragile growth. If austerity were what the economy needs, we would all be happy to let the economy drive over the fiscal cliff. Instead, politicians on both sides rightly fear it. This reveals not only that continued austerity is harmful but, more interestingly, that we all know it. After all, our current economic travails are caused by a lack of demand. If consumers are nervous about spending, then firms will continue to shed workers, making consumers even more wary of opening their wallets. This is the textbook moment for the Keynesian solution of allowing increased government deficits to spur spending, thereby kick-starting the private sector.

So why do politicians from George Osborne in the UK to Alan Simpson and Erskine Bowles in the US keep banging on about the deficit? The answer can be found in an article by the brilliant Izabella Kaminska. She looked back at the New York Times archive from the 1930s and found the same desire for austerity and fear of government spending that we suffer from today. We now know that continued austerity made the Great Depression much worse—it was only the massive spending to fund the second world war that ended the Depression.

Since John Stuart Mill in the nineteenth century, economists have reconciled Say’s law, which says that all income should be spent, with the existence of recessions by noting that sometimes holders of cash don’t want to spend it on everyday consumption or investment in capital goods but rather on safe financial assets (such as bonds) with which to secure their future. This means that the flip side of a lack of demand for current production can also be understood as a lack of supply of safe financial assets. Shares remain expensive, bond yields are miniscule, and GDP to debt ratios remain high.  Were asset holders confident their wealth was safe, they would be borrowing and spending like it’s 2005. Instead, they are shedding debt, further slowing the economy.

Bondholders naturally fear inflation more than anything else.  Creditors are always terrified of being repaid with devalued currency. Kaminska’s trawl through the archives reveals that “people were just as worried about debasement-induced inflation and money printing in the 1930s as they are today. That’s despite the US Great Depression ending up as one of history’s best examples of a prolonged deflationary period.” She suggests that when investors have difficulty finding safe financial assets, they insist that maintaining the value of those assets must be a priority. From the Latin American debt crisis of the 1980s to Greece today, austerity is always the preferred policy of the holders of financial assets.

Perhaps this helps explain George Osborne’s continued advocacy of fiscal contraction even as it unnecessarily devastates our economy. The rich, who are net creditors, desperately fear that any monetary and fiscal expansion will end up eating up their capital. Thus they deny the rest of us the medicine our economy so desperately needs. Our confusion about the fiscal cliff serves their interests.