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Monetary and Fiscal Policy in Early 2013

November 20, 2012

There’s broad (not universal) agreement that everything should be on the table, tax increases, the possible elimination of deductions, entitlement reforms, and cuts to defense and other types of spending. That’s not what the fiscal cliff is about. The fiscal cliff refers to doing too much too soon to reduce the deficit and the negative impact that would have on the economy.
-Scott Brown, senior vice president, Raymond James

The fiscal cliff refers to a substantial tightening of fiscal policy in 2013. Monetary policy cannot offset the cliff’s negative effect on the economy. However, it would be surprising if a deal were not reached, if not by the end of this year, then in early 2013. Due to concerns about the long-term budget picture, some of the cliff is almost certain to get through.

Alright, we’ve been over this and over this, and I’m going to keep going over this until I stop getting questions. Okay? There are two issues with the fiscal cliff. One is that the federal budget is on an unsustainable trajectory. No one disputes that or argues that we shouldn’t address it. There’s broad (not universal) agreement that everything should be on the table, tax increases, the possible elimination of deductions, entitlement reforms, and cuts to defense and other types of spending. That’s not what the fiscal cliff is about. The fiscal cliff refers to doing too much too soon to reduce the deficit and the negative impact that would have on the economy.

As any student of Econ 1 learns, raising taxes or cutting spending is contractionary fiscal policy – it dampens the pace of growth. That’s not to say that there may be cases where budget austerity has economic benefits. For example, deficit reduction under the first President Bush and Bill Clinton was viewed by some as helping to reduce long-term interest rates, which contributed to a capital spending boom in the late 1990s. However, we’re currently seeing no signs that government debt is crowding out private borrowing. Without any offset from the interest rate channel, contractionary policy is contractionary.


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