A Fiscal Cliff of Our Own Making

Countries often run up deficits as they try to revive flailing economies, but reining in deficits during shaky fiscal times can be perilous, says Fletcher School economist Michael Klein.

The self-imposed “fiscal cliff” the U.S. is facing on Jan. 1, when taxes will rise and government spending will be sharply reduced (unless, of course, Congress reaches an agreement to rescue us from the precipice) may do more harm than good, says Klein, who served as chief economist in the U.S. Treasury’s Office of International Affairs last year. He points to rounds of tax increases in the midst of the Great Depression that sent the country spiraling again and to the austerity measures the British government imposed in 2010 that stalled economic recovery there.

Politics, not economics, brought us to this point, argues Klein, the William L. Clayton Professor of International Economic Affairs at Tufts. He says a large national deficit is not as dire as the political dysfunction in Washington.

With compromise in short supply in Congress, as Klein puts it, bridging the impasse about how to increase revenues and cut spending will be tough. But did we really need to be approaching the brink in the first place? Tufts Now asked Klein how we got to this point and whether we can avoid plunging off the cliff.

Tufts Now: Should be we concerned about reducing the deficit?

It’s standard that when countries go through a recession, their deficits get bigger. And in fact, that’s good for all of us, because it mitigates the extent of the economic downturn. If we don’t offset falling tax revenues with increased government spending and investment, the economy gets into an even worse situation. It’s true that when your deficit is larger, your national debt rises. Right now the U.S. debt-to-GDP (gross domestic product) ratio is just over 100 percent, meaning slightly more debt than income. This does affect the country’s financial rating, which can increase borrowing costs.

So we do need to bring that ratio down?

The question we face now is, Does that ratio reflect a fundamental problem that will keep the debt-to-GDP ratio rising even after the economy recovers, or it is just a temporary condition? If the economy keeps rising, deficit reduction would not require huge changes; it could be handled with minor alterations that were timed appropriately.

You don’t start raising taxes on the middle class in the middle of a recession. We’ve seen the consequences of this. In the 1930s in the U.S., there was a concern about the federal deficit. So in 1936 and 1937, taxes were raised across the board, which sparked the second dip of the Great Depression.

There’s an interesting parallel in Great Britain. When [Prime Minister] David Cameron came to power in 2010, there was concern about very big deficits and rising debt ratios, so his government put in strong austerity programs—like our fiscal cliff. Since then the British economy has been very weak. If you track the British and U.S. economies through 2010, they were close to parallel. But after the British put in austerity programs, their economy did much worse than ours.

What happens if we do fall over the fiscal cliff?

We are going to have a really negative outcome, unless the politicians get their act together. Massive spending cuts and across-the-board tax increases could not only slow a weak recovery, it could create a downturn. If we went over the fiscal cliff, smaller paychecks and diminished government programs would affect not only spending and business productivity, but people’s confidence.

Markets would react to this information right away, and you could see the stock market tanking. Politics is slow, and markets are fast. We already live in a political environment that is seen by many as very dysfunctional and adverse to economic prosperity, and this would just reinforce that view.

Given these realities, why won’t Republicans and Democrats compromise?

There has been a Republican push for smaller government for a very long time, so it’s like the saying goes, “Never waste a good crisis.” In this case, it is a way for them to achieve these other goals. And the Republican leadership is laboring under very difficult circumstances, where one wing of the party has made a very strong commitment never to raise any taxes and is especially averse to raising taxes on the wealthy. They also want to cut entitlements. My perception is that the Democrats are reasonable in saying that we need to be on much firmer footing before we start cutting programs too drastically. [President Obama’s] plan does have an eventual reduction in entitlements balanced by taxes on the wealthiest.

Is it better for the economy to keep taxes low for the wealthy?

People who have studied this suggest that cutting taxes on the wealthy is far less stimulative for the economy than people in the political sphere are saying. Think of it this way: When you cut taxes, people have more take-home pay, so the people who basically spend all their take-home pay—because they can’t afford to save very much—will be likely to spend more. Tax cuts on the wealthy, people who already save a lot of their income, would likely result in them just saving more of their income, not spending it.

Would higher taxes on the rich lower the cuts to entitlements and other government programs?

Proposed entitlement reforms are not that dire—we’re not talking about cutting public workers’ salaries by 50 percent, the way they are in other countries. The real question is, Who should be funding the reforms? We need to think about rising economic inequality in the U.S. and ask, Is it really fair to balance the budget on the backs of those who didn’t benefit much from the economic growth of the last 20 years, especially compared with those who did very, very well?

In your opinion, how will this end?

It’s not clear what’s going to happen over the next few weeks, because there is so much political posturing. But it could be pretty adverse, given how weak the recovery is and the limited tools that are available to fix it. Monetary policy is already hamstrung by low interest rates. But the polls these days are suggesting that if we do go over the fiscal cliff, the Republicans will be blamed more than the Democrats. It really is a political issue more than an economic one. It showcases that this political system has been very dysfunctional for a long time.

Gail Bambrick can be reached at gail.bambrick@tufts.edu.