## Tuesday, November 27, 2012 ... /////

### It's wrong to worry about the "fiscal cliff"

Starting from January 2013, America has a chance to restore some balance in its federal budget that's been getting worse since Clinton's surplus years around 2000 and that switched to seemingly permanent astronomical figures after the 2008 recession.

If no bills were changed or added in the following 6 weeks, spending cuts would come into force and some temporary (mainly Bush) tax cuts would be abolished again. The deficits would instantly start to improve, see the brown curve:

However, some people invented the term "fiscal cliff" for the relatively sudden improvement of the U.S. budget deficit in order to suggest that this good thing is actually a bad thing. It's a fiscal cliff but the sign is such that the U.S. may start to climb out of the deep Greek $hit it's been sinking into. But a "hike from the mud in the Mariana Trench towards the summit at Mount Everest on a sunny day" doesn't sound as catchy as the "fiscal cliff". The advocates of this "evil fiscal cliff paradigm" are mixing some of the usual crackpot left-wing economical misconceptions. They say that a too large part of the reductions of the deficit would be paid by the middle class; and they say it's bad to improve the finances discontinuously. You may see that the first complaint is just populist demagogy; and the latter is just a wrong model of economics. It's good that at least some writers, e.g. Michael Sivy in the Time Magazine and WSJ's Jonelle Marte, agree that it's wrong to worry about the "fiscal cliff". Concerning the first objection, about 2/3 of the deficit reduction would be paid by the middle class. One is expected to be upset that it's a high percentage. I am amazed by such reasoning. The middle class is the class that mostly "owns" the political system of America – the class whose a$s must be licked by pretty much every realistic politician in the country – so it's obvious that it must pay the majority of the money, too. The middle class is estimated to represent 45% of the U.S. population but it depends on the definitions.

However, the "poor class" doesn't pay almost anything and consumes a lot of the state expenses. So you only have the middle class and the "rich class", or whatever is the name. The "rich class" clearly can't pay all (and not even most of) the public expenses even though it's clearly a favorite dream of socialist populist demagogues who have forgotten that socialism only works until you run out of other people's money.

So in a working economy, most of the burden simply has to be carried by the middle class, by the "largest productive class". It's almost a tautology.

But it's obvious that there will be differences between left-wing leaders and right-wing leaders. Right-wing leaders will try to introduce some kind of a fair distribution while the left-wing leaders prefer a criminal system that steals the money from the successful and throws them to the unsuccessful, jealous, lazy 47%, so to say. It doesn't work, anyway, because when a high-paid employee is needed in a company, the company – and, therefore, indirectly poorer people in the company – must pay him whatever is needed so that he has a sufficient amount of money after taxes, anyway. Let me not talk about the distribution of the tax burden because it's a matter of political and moral preferences. Quite generally, the progressive tax system is silly. The real competitors should be the flat tax and various types of regressive systems but it's almost politically incorrect to even pronounce this trivial fact these days.

Instead, let's focus on the other objection, namely the opinion that it's unhealthy for the economy to reduce the budget deficit abruptly. It's just silly. The budget deficit is something that should be just a small perturbation of the country's GDP – some random number close to zero or 3 percent of GDP or whatever deficits you find tolerable in the long run. Because and as long as it is a nearly infinitesimal random number, it can't hurt when it's changed abruptly. It's what random numbers do (if they're white noise).

Needless to say, this description doesn't hold for the U.S. budget because it's not a small random number. Instead, it has become predictably huge. And it's a major problem. When the budget deficit is immediately brought close to zero, it's simply a cure to a bad condition so it can't possibly be bad. When your stomach's pH differs from the recommended value (about 2-3), it doesn't hurt when you bring the pH to the right value instantly i.e. discontinuously. Note that when expenses and revenues jump discontinuously, people's "worth" is still continuous. One needs to go to the second derivative of "worth" to see a delta-function and it's normal for a the second derivative of the "worth" to have a similarly singular behavior. Trying to make even higher derivatives smooth would be even more preposterous.

Now, when the government abruptly reduces its large budget deficit, it surely leads to a drop of the GDP. The GDP is the most inclusive measure of the economic activity which is why it's used as the measure of the wealth of countries by those who respect economics as a quantitative science. And so do I. However, the health of the economy is only an increasing function of the GDP assuming that certain imbalances are zero. If they're not zero, it's a subtle question how the most natural definition of the "health of the economy" should treat these imbalances.

Let me propose the following measure to replace the naive GDP:

LMGDP = GDP – Budget_deficit
If there's a surplus, LMGDP will be greater than GDP but I kind of doubt that the U.S. will need this extra comment anytime soon. ;-)

What is the logic behind LMGDP? It's simple. When there's some budget deficit, it means that the government pays for certain services or products that would be unsalable if the deficit were what it is supposed to be, namely zero. Imagine that the most natural way to eliminate the deficit is to reduce the cheques that the government is directly paying to various groups of citizens who almost instantly spend the cheques. If you reduced these cheques to balance the budget, these people would buy less and the production would have to drop by the same amount (let's assume they're buying purely domestic services and products, for the sake of simplicity, although I realize it's not the case – but I don't want to discuss the trade deficit now).

So if the distortion of the market conditions caused by the budget deficit were eliminated, the GDP would drop approximately by the budget deficit itself. That's why LMGDP is a nicer measure of the "undistorted economic activity" in a country. One simply wants to subtract the "fake activity" that was really paid for by subsidies and no one would want it if the conditions weren't distorted.

So the right question isn't what GDP will do when the budget deficit is abruptly reduced; a much better question is what LMGDP does. And I am actually not sure whether the policies that may come into force since January 2013 will increase or decrease the LMGDP. If they will increase LMGDP, i.e. reduce the GDP by less than the amount they subtract from the deficit, then the changes that may apply in January 2013 are clearly a good thing in my understanding of the situation.

Incidentally, it's fun to think about the value and evolution of the Greek LMGDP instead of GDP as a function of time. When the budget deficits become significant, LMGDP gives you a completely new viewpoint from which you may evaluate the situation. In particular, it's useful to quantify the countries' debt as percentage of the annual LMGDP. For countries like Greece, you will get a much larger – and much more realistic – percentage. The Greek "actual" or "undistorted" GDP – and LMGDP is a way to quantify it (although I think that an even lower figure than LMGDP encodes the "corrected equivalent GDP" of Greece) – is actually much smaller than the conventionally used GDP. That's why the percentage we often use – debt at 160% of the GDP, and so on – understates the severity of the actual problem (a greater-than-visual-field problem that will only be seen in its entirety once Greece actually starts to cure the imbalances if it ever does). Whatever currency Greece will use, if it doesn't bankrupt, it will ultimately have to see that the actual "undistorted GDP" – e.g. LMGDP which isn't artificially doped by the budget deficit steroids – is much smaller, and the debt is therefore a significantly higher multiple of the undistorted GDP.

If the U.S. turns out to be unable to bring its deficit to tolerable levels closer to zero – whether or not its economists fabricate a new propaganda "explaining" why such a deficit reduction is a bad thing – it will only mean one thing: that the country's problem is really a long-term one and serious investors should trust the country in the future much less than they have trusted it so far. If America isn't capable of swallowing the "fiscal cliff pill" sufficiently quickly, then it's a country that is addicted to debt and going towards the Greek-like "fiscal chasm" – and be sure that the sign of this chasm is opposite than the sign of the good old fiscal cliff.

And that's the memo.

#### snail feedback (18) :

reader Luke Lea said...

I take it you would be opposed to a monetary policy designed to temporarily increase inflation to the five or six percent range as a way to decrease the real debt of of both government and consumers, decrease real wages, and bring about an expansion of employment at a lower standard of living?

reader Luboš Motl said...

Yes, of course, I would be opposed - in my country or in any country I care about. I think that all such distortions of the market conditions - e.g. your "deliberate inflation bump" - are undesirable. Stable currency is the fairest dependence of its value on time because stability was what was assumed in all the contracts.

Your sleight of hand is nothing else than a selective punishment of savers and "affirmative action" bringing an advantage to those in debt - which includes the (typical Western) government. too. Such a policy is particularly sick in the situation when the debt is already high because it encourages the chronic borrowers (including the government) to borrow even more in the future while it spanks the savers - and responsible public bodies etc. - and tell them that they should pile debt just like everyone else. It's not only doubly unfair but it's also accelerating all the negative trends.

In my country, such pro-inflation ideas, while widespread among the top bankers, are even more sick because we're a country of savers rather than borrowers and inflation leads to the decrease of the real wealth of the real savers who are extremely important for the home consumption, and therefore reduces the real domestic consumption.

Also, your hypothetical positive consequences of the maneuver are rubbish in the medium and long term because foreign lenders will inevitably demand higher interest rates to cover the inflation and expected possible later inflation, too.

I think that your last sentence must have some mistake in it. Income tax is something else than tax on savings, isn't it? I consider the value-added-tax to be a very modern way for the government to get revenue and I think that the system in which the VAT/sales tax would be higher and income tax could be completely eliminated would be superior because of many reasons. But I am amazed by the adjective "graduated" that you stubbornly insert everywhere. Do you mean progressive? I surely oppose progressive tax, both progressive income tax and progressive sales tax. I can't even imagine how a sales tax could be progressive, when it comes to practical issues.

We've been the most socialized country in the world but I assure you that both our income tax as well as the value-added tax is flat. Well, we have 2 rates for VAT tax, 14% and 20% or so, for different kinds of products and services. It's a detail. But it's surely not progressive as a function of the consumers' wealth. It would be a complete legal and bureaucratic nightmare to make the rate wealth-dependent in this way.

reader Luke Lea said...

I take it, then, that you are ok with the "natural" distribution of income (and consumption) in a market economy. Fair enough. Does it necessarily follow that you would favor free trade and free mobility of capital between the West and a vast, low-wage Goliath like China? Should the effects of such trade on the distribution of income between labor and capital (lowering wages but increasing total GDP) be of concern?

reader anna v said...

Inflation is part and parcel of a capitalistic economy if left without checks and balances, and even with them.

I worked in the summers in the US back in 1960 for 132 $a month. Those jobs now get a multiple of that . Inflation happened though probably not controlled. In a sense you propose a controlled stability, not free capitalism, the opposite view proposes a controlled inflation ( which I think I was taught back in 1961 in economics 101 as the way to go). Another example of "inflation happens in uncontrolled capitalistic systems" is feudal Europe ( and feudalism is where such systems end up) where when they discovered and brought back the gold of the Incas the price of eggs became a gold coin in Spain. The effect will be the same if , for example, solar panel technology becomes very cheap and energy prices fall by 90%. The world economy at the moment is experimenting in free for all capitalism with no checks and balances either way. How can islands of stability, as you propose, survive in this environment? reader Luboš Motl said... Dear Luke, I don't know whether it follows but I obviously support tree trade, between rich and poor, straight eyes or slanted eyes, everyone. Of course, the Czech economy heavily depends on trade's being (almost) free. And I assure you that our products are "mostly" competitive with the Chinese ones even when it comes to the value and if they aren't, it's inevitable that the producer etc. ultimately goes out of business. Wages may only be as high as the market allows. One may be "concerned" that his wage is lower than he dreams but it's similar as being "concerned" that the Earth is spinning around its axis. One must just accept basic laws and the pressure from the market competition is surely such a law. Attempts to deny these basic laws are ludicrous and hypothetical policies making free trade impossible would surely be more devastating than living according to the laws of the free market. I don't understand what is "extreme" about your theme. What is extreme is your suggestion that one should restrict free trade. Not even commies have been proposing anything of the sort in my country. reader Luboš Motl said... What you write is complete rubbish, Anna. Inflation has nothing whatsoever to do with the economy's being capitalist or socialist or otherwise. And a stable currency isn't matter of regulation of the economy: it just means that the people using a payment tool - money - choose a "constant enough" definition of the unit, and/or an external party that guarantees the constancy of the unit. It's similar to having judges or arbiters who are fair. It's an advantage to operate in this way. But it's not about the regulation of the economy: we're talking just about a damn unit, a benchmark to calculate payments and wealth now and in the future. There have been and there are non-capitalist countries with huge inflation and there are great capitalist countries with almost zero inflation. Inflation is just the deterioration of the value of the typical payment tool relatively to goods. That's it. The unit used for payments is ideally an external quantity - that's why capitalism worked (and, in a limited geographic context, could still work) very well when people paid by gold which isn't man-made at all. That's why national economies may smoothly use currency of completely different nations they have no control with, and so on. Whether these units of money lose their value is an external question that has nothing whatsoever to do with the intrinsic properties of the economy. In some eras, one may discover significant inflation, in others, it's much smaller. It's clear that inflation above the 3-5 percent level is a significant problem - if nothing else, because of the need to constantly rewrite the price stickers. ;-) Incidentally, the inflation you mentioned isn't insanely high. In 50 years, you report the increase by the factor of 25 or so. That's great but the 50th root of 25 is 1.066. Now, it's not true that the whole 6.6% is inflation. About 1/2 of it, or 3%, is the average inflation - and the rest is the real income growth. People may just afford to buy more stuff than in the 1960s. reader anna v said... Suppose the whole world manages to have a fixed currency in the way you suggest, and there is free trade and movement of money and businesses all over the world, what do you foresee will happen? I think that a balance will arrive and the countries with small per capita will rise to the average per capita income for the world, and the countries with high per capita will fall to the average per capita income of the world. Until then businesses will be moving out of high per capita countries ( as is happening with the US) to the low ones , China and India at the moment. This chart is enlightening http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28nominal%29_per_capita As Europe is top cat in this game, the only way is down to the average. Is this desirable? reader Luboš Motl said... Don't be silly. If the whole world used the same currency - I am in no way proposing that this is optimal for all nations; quite on the contrary, it's a very good idea for nations and regions to have national or regional currencies because the world isn't an optimum currency zone - the currency could be rather stable and it could even be called the U.S. dollar. The current situation doesn't differ from this scenario of yours too much. Much of the world either uses the U.S dollar or currencies that are more or less pegged to the U.S. dollar - like China - and even those who use different currencies see exchange rate swings that aren't qualitatively significant. They usually change by a few percent a year only. So your idea that the switch to a single global currency - which isn't a big switch - would create some kind of world egalitarianism is something so incredibly stupid that I can't believe that you actually believe what you write. It's dumb beyond imagination. Almost nothing would change if the world were using the same currency. There are actual physical reasons why some nations have 10 or 20 times smaller GDP per capita than others. They're just not as skillful, hard-working, motivated, disciplined, and/or haven't developed a good enough infrastructure, education, and other things. Or they were not lucky or they don't have natural resources or they don't have other useful things. But your idea that the wealth of nations is an artifact of some numerical calculations dependent on which currency they use is just dumb beyond imagination. Incidentally, Greeks have tried to maintain living standards at the level of Germany and often higher - you still have higher average pensions in Germany - but all of this has been life beyond reality. Whatever currency you use, the only sustainable living standards will be about 3 times lower than the Czech ones, and just to be sure, the real Czech income is currently 4 times lower than the German one. If any balance and sustainability is to be restored in your finances, your salaries need to go an order of magnitude down simply because you're not a skillful, disciplined, hard-working nation relatively to others. Yes, I think that a sustainable Greek salary has to be lower than the Chinese salary. But this has nothing whatsoever to do with the unit that you use as the currency. reader John_in_Oz said... When Bush introduced the Bush tax cuts, U.S. Government receipts increased. Presumably, the reverse will happen when they lapse. I don't believe the U.S. has the political ability to stop spending more than it takes in. It will collapse, taking the world's economy with it. People will continue to support the unsupportable for as long as possible, since there will be reweards for doing so right up to the last, at which point the last man in will be the sucker who pays for all. reader Luboš Motl said... John, I don't know what will happen with tax revenues but of course if the tax rates are increased, the revenue doesn't increase as much as simply given by proportionality, to say the least. I also tend to agree that the U.S. is almost unable to shrink its expenses again and it's the main problem, not the tax revenues. Otherwise, America isn't a vein running through every person and economy in the world. It's silly that the world economy would "collapse" if the U.S. were in serious problems. The world just doesn't work like this. Take Czechia, a heavily trade-dependent economy where the foreign events translate "more strongly" to domestic changes. Still, the U.S. doesn't belong among the top 10 business partners and the trade with the U.S. represents something like 1% of our trade. You could say that it's because we're trading with Germany and Germany depends on the U.S. But it's not that significant, either. First, Germany is only 1/3 of our trade and the U.S. is only 5% and 7% of Germany imports and exports, respectively. If the U.S. ability to pay dropped to 1/2, it would be hardly detectable. Of course that one could see it in accurate numbers but normal people and companies wouldn't feel it beyond the normal noisy swings they experience anyway. reader John_in_Oz said... With respect, Lubos, you're as bad at macroeconomics as economists are at particle physics. Before I substantiate that claim, let me provide this link to an article that explains how much worse the U.S. economy is than they claim: http://hockeyschtick.blogspot.com.au/2012/11/true-us-debt-now-exceeds-278000-per.html Admittedly, I must confess I have only a single semester's study of the subject myself, as an undergraduate. However, it's not merely the collapse of your international trade that will follow the U.S. collapse. Most of your banks have significant assets in U.S. dollars. When they become worthless, many of your banks will become bankrupt. Much of the world's capital is held in U.S. dollars. When they collapse, your economy will abruptly stop having investment capital available. Interest rates will skyrocket. Mortgages will become unaffordable, and homes will be foreclosed. Businesses will be unable to afford their overdrafts, and companies will collapse. The contraction of the world economy will escalate, with many other companies, such as resource producers going bankrupt. Your country will find itself unable to support its own industries, as the drop in wages of other countries more affected by the depression means they can outcompete your labour supply. The suggestion that America is a vein running through every country is nearly right. American capital is the lifeblood of the world's economy. reader Luboš Motl said... Most of your banks have significant assets in U.S. dollars. Sorry, but this key basis of your ambitious claims is completely untrue. Crackpot economics such as yours usually starts with totally wrong data but totally wrong maths and logic has to be added, too. In reality: The Czech commercial banks have virtually no U.S. dollar reserves except for the central bank (Czech National Bank) whose 62% (of the total$43 billion) of reserves is in the U.S. dollars.

http://zpravy.e15.cz/byznys/finance-a-bankovnictvi/devizove-rezervy-cnb-v-srpnu-klesly-na-31-6-miliardy-eur-912176

The commercial banks have almost no exposure to the U.S. dollar and the percentage of people's savings in the U.S. dollars is close to zero. That's also why the "financial crisis" of 2008/2009 didn't exist in the Czech Republic - only secondary effects of reduced demand from abroad has been visible and it still tends to continue. Fix your facts.

There are countries that work on U.S. dollars and of course, their savings and reserves would drop if the U.S. dollar would drop. But that would imply neither an increase of interest rates for the local currencies if they exist nor a drop of the GDP.

The suggestion that America is a vein running through every country is nearly right. American capital is the lifeblood of the world's economy.

That's just your naive childish version of nationalism. The U.S. is the largest single economy in the world but it simply produces just 25% of the world's GDP and this quarter is as important as any other quarter. Moreover, because of locality of the laws of physics and most laws in economics. a complete elimination of the U.S. from the surface of the globe would have just a slight, perturbative effect on the rest of the world.

reader Luke Lea said...

Dear Lubos, Rest assured that I am pro-market and pro-free trade also, no less than you are. The only difference is that I also favor income redistribution (via government wage subsidies and a graduated expenditure tax) in order to make a free market economy work for dumb people too, especially those who are my fellow citizens.

P.S. People will never agree about economics. It is worse than religion. Not sure why but it is an evident fact. Still I appreciate your views. Maybe they are the best possible. Mine don't seem to be possible. best,

reader Hal Burton said...

Tax hikes aside, and the resultant decrease in revenue from those tax hikes, the better solution is to deny an increase in the debt ceiling. This would cause an instant balanced budget. No check could be printed unless the money was in the bank to cover it.

reader Hal Burton said...

My last comment aside, I came here looking to see what a genius had to say about the black hole finding.
---

Monster Black Hole Is Biggest Ever Found
With a mass equivalent to 17 billion suns. "The giant black hole is about 11 times as wide as the orbit of Neptune around our sun, researchers said." [rdbrewer]

Judging from the incredible CIA/ US Military fiasco unfolding, let's
triple the cut on the military via the cliff. A "20 car caravan" to the
love nest? Do the words of Dwight Eisenhower mean anything to anybody in this country?

"In the councils of government, we must guard against the
acquisition of unwarranted influence, whether sought or unsought, by the
military industrial complex. The potential for the disastrous rise of
misplaced power exists and will persist. "

Dwight D. Eisenhower 1961