In the Market Monetarism camp, I’ve noticed a mixed level of confidence that the Federal Reserve will offset the economic implications of the so called fiscal cliff. There is no question about whether the Fed can offset the cliff. It did in the 1990’s and it can again, even at the ZLB. Lars Christensen has said he believes the Fed will offset the cliff in one of two ways. It will either continue to follow its “Evans-Bernanke” employment rule, or it will respond to declining inflation based on its inflation target as further declines in either would indicate a need for expansion of QE3.
Mr. Christensen may indeed be correct. But I am skeptical. I expect no more than a rough go of it due to the rather wobbly nature of the policies in place. There is no level targeting commitment, which means that damage will be done before the Fed responds; and there is a big difference between prevention and cures for events that can be quite clearly anticipated. The time for the Fed to mitigate market and economic damage from the fiscal cliff was two weeks ago. It isn’t next month or the month after when inflation and employment start to flag.
Bernanke has expressed doubts that his policy regime can overcome the effects of the cliff. Whether he is expressing willfulness or what he believes to be fact doesn’t really matter. He has the luxury of selecting his own facts and the markets have responded with early profit-taking while the taking is good. There is no “Rooseveltian Resolve;” and the future has already influenced the present, making the hill to recovery steeper than necessary.
I received a Gingrich Productions news letter in my inbox several days ago. As some may already know, Mr. Gingrich has been in the periphery of the negotiations to avert the cliff in the role of helping to provide cover for Republicans who may have decided to allow tax rates to increase. In the news letter, he provides some insight to his thinking regarding tax rates:
There is no such thing as a fiscal cliff. It is actually more like a bunny slope … The impact will be some pain to a lot of people. But in fact we survived the ’90s paying Clinton-level taxes. I’m just saying. So this is not like we are going to go off a cliff. Will some people be hit hard? Yes. Will some defense contractors be hit hard? Yes.
The essential piece missing from this political equation is that Greenspan did what was needed to avoid the impact on AD from changes in fiscal policy so that those hard hit could find something else to do in the free market, making reallocation of resources faster. That is why we survived under the Clinton era tax rates. It’s not like we now have an abundance of opportunity out there with the Fed currently so far behind the NGDP “ball” it will take years of makeup growth just to recover from the Great Recession let alone any effects from fiscal tightening in 2013. The current set of circumstances will require much more from the Fed in the way of boosting income expectations – which is pretty difficult to do at the ZLB with a muddled inflation/employment policy. The communications focus on inflation is all wrong; and I just don’t think it will work.
NGDP level targeting really is the only way out of this mess. The longer it takes for the Fed to change the policy regime, the longer we will be blown about by every wind. It’s sad because this condition is completely unnecessary and avoidable – and we should be demanding more from public servants than what we’re getting if the goal is to have an opportunity society where self-sufficiency is a primary personal obligation.