A brief perspective on the cliff deal

So it seems that a deal on the fiscal cliff has been reached, and was approved by a large margin, 89 to 8, in the Senate. The deal basically raises income taxes to pre-Bush tax cuts levels on families making more than $450,000 a year and individuals making $400,000, and raises the estate tax on the biggest inheritances too. Estates of more than $5 million would be taxed at 40%, up from the current 35%. It also does not include any cuts in Social Security or Medicare (the main tactics used for cuts were changing the price index for Social Security adjustments and increasing the age limit for Medicare).

More importantly no spending cuts really, which means the long term unemployed will continue to receive a check every week, and we will not add another drag on a very mild recovery. If no concessions are made on the debt limit in the next two months, a double dip recession this year might be averted. So progressives should be really happy.

The NYTimes editorial is unhappy because "this deal is a weak brew that remains far too generous to the rich and fails to bring in enough revenue to deal with the nation’s deep need for public investments." In all fairness, that's silly. It is true that Dems could have gotten more revenue from tax increases on the wealthy, but the US has no long term deficit problem other than rising costs of health, and no problem to finance public investment at all. To deal with the first a public option is the solution, and the limits to public investment are purely political.

The agreement actually makes the US political system look less dysfunctional than the European, which continues to be tangled in their austerity policies. All in all, a pretty decent start for 2013.

PS: Not sure why Krugman thinks that the agreement has left "a bad taste in progressive's mouths." Seems that he is afraid that the insufficient increase in taxes will let welfare programs vulnerable to the starve the beast argument. Again I think that risk is purely political, and a bit more revenue from the wealthy would have done little to eliminate it.

The IMF still believes in fiscal austerity

In May, Olivier Blanchard, the head of the research department at the IMF, said:

"Earlier fears of a double-dip recession—which we did not share—have not materialized... The inventory cycle is now largely over and fiscal stimulus has turned to fiscal consolidation, but private demand has, for the most part, taken the baton."

The lame excuse for this ludicrous forecast now is that:

"the initial U.S. data understated the size of the slowdown itself. Now that the numbers are in, it is clear that more was going on."

In all fairness I criticized that view in May (here) and in July (here), since it was clear that fiscal austerity (Blanchard says consolidation, but he means reduction of spending and increases in taxes, that is austerity measures, which may not lead to a reduction in deficits, i.e. consolidation; one day I'll publish the IMF-English/English-IMF Dictionary) would not work.

Now that he admits that private demand has not taken the baton you think he would admit that fiscal consolidation (austerity really) is not the solution. You would be wrong, of course. He says in the new World Economic Outlook foreword (WEO, Sept, 2011) that:

"Fiscal consolidation cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility."

Not very different from what Christine Lagarde, his boss, has been saying. That is, we need fiscal austerity, but not too much (see my critique here). The new claim (in the last WEO) is that China has to import more, since the US private demand will not pick up (and fiscal austerity is needed).

By the way, according to the IMF China will grow 9.5% in 2011, and the yuan has appreciated strongly in real terms (particularly when you deflate by the real wage, that grows astronomically in China). So it's unclear how China could, besides growing sufficiently fast to keep a good chunk of the world economy (in particular exporters of commodities) expanding, also get the US out of its recession.

Perhaps, Blanchard and the IMF should revise their views on fiscal policy for developed countries (the IMF could also change it's adjustment programs based on austerity in Europe too!).

Robert Barro does not believe in evolution

Okay, in all fairness he does not believe in expansionary fiscal expansions. But it is the same. All the evidence supports the functioning of the simple Keynesian multiplier. One might disagree about its size, but not its existence. Barro says that we are in:

"the third year of a grand experiment by the Obama administration to revive the economy through enormous borrowing and spending by the government."

You would expect that at least when referring to the data he would be accurate, but evidence has nothing to do with how he understands the economy (remember this is the guy of Ricardian Equivalence, i.e. if the government increases spending, people raise their savings proportionally to pay the future anticipated taxes with no effect on output).

The graph below shows percent changes in total government spending and revenues since 2006.

As it can be seen, spending (in red) increased in 2008, as a result of the recession, but has been falling ever since. The deficits are caused, not by an experiment in Big Government as he suggests, but because revenues fell.  And yes the recovery, even a mild one, led to a significant increase in revenue last year. In 2010 revenues increased by 7% from previous year, while spending did it by only 0.7%. That's why in the first year of Obama's own budget, in 2010 (2009 he inherited from Bush), the size of the deficit actually fell (a bad thing, by the way, in the middle of a recession). So to avoid a double dip recession we need to do the opposite of what Barro says.

PS: Krugman also criticizes Barro here.

Deep double dip thoughts

Okay, so it seems that more and more people think that we are in for a double dip.  The Economist has said:

"the odds of a double dip over the coming year are uncomfortably high, perhaps as high as 50%."

Before you take them too seriously remember that they also say a few lines down that:

"the thoughtlessness of the debt deal—notably its failure to tackle any of the real sources of America’s fiscal problems, such as entitlement spending—raises a bigger worry."

As everybody knows that the fiscal problems result from the recession, Bush's tax cuts, and the two wars, they are just deliberately ignoring the truth, or worse, blissfully unaware of what's going on.  The worry is not about the fiscal situation, and that is why markets have rushed to buy Treasuries in the middle of the crisis this week, after the S&P downgrade (Bob Kuttner got it right, those guys are just Triple-A idiots).  I won't even talk about Ken Rogoff's argument (in the Financial Times) that "the biggest deficit is not in credit, but credibility" [is there a credibility fairy too?].

In truth, as noted (subscription required) by Joe Stiglitz in the Financial Times, at core this is a political crisis. Both in the US and in Europe the inability of the political elites to cope with the crisis, implies that fiscal stimulus (and in Europe not even low rates of interest on public debt for the periphery) is not in the horizon.  In other words, more than a double dip, since the recovery was never really very strong, we'll remain in a limbo of stagnant growth in the center.  Japan redux.

However, does that mean that we'll have another Lehman moment with a collapse of financial markets, and the collapse of trade, hurting the strong recovery in the periphery?  That is less likely, but not an impossible scenario.  Note that last time, the collapse in trade had significant impact in the economies of the periphery.  This suggests that more mechanisms to maintain South-South trade going in case of a collapse of the financial system in the center might be a good idea.

PS: Dean Baker argues that the recent stock market panic is related to a possible Lehman moment coming from the on going European debt crisis.