Bernanke's Cliffhanger

The 2013 fiscal danger is a tax increase, not spending cuts.

Everyone is suddenly waking up to the horrors of the "fiscal cliff" that arrives on January 1, 2013, but the real clear and present danger keeps getting misdiagnosed. It's the taxes, not the spending.
On Capitol Hill Thursday, Federal Reserve Chairman Ben Bernanke didn't endorse one more round of monetary easing. But he did join the Keynesian chorus decrying "a severe tightening of fiscal policy at the beginning of next year that is built into current law—the so-called fiscal cliff [which] would, if allowed to occur, pose a significant threat to the recovery."
His recommendation to Congress: "I am telling you, try to avoid a situation where you have a massive cut in spending and an increase in taxes hitting all at the same time, as opposed to spreading them out over time." Just what Congress needed: a lecture not to cut spending.

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At least Mr. Bernanke got it half right. There are two distinct fiscal cliffs ahead: first, the rise in tax rates because the Bush reductions are set to expire under current law. This is dangerous and should be postponed pending a reform of the tax code.
The second cliff is the $1.2 trillion in automatic cuts in military and domestic discretionary spending over the next decade as agreed to in last year's debt-ceiling deal. In 2013 these cuts come to roughly $126 billion. The depth of the defense cuts would damage national security, but the economic impact of all of those spending cuts would be benign, even beneficial.
The idea that spending cuts will curtail the recovery is the same fiscal multiplier nonsense that gave us the $830 billion stimulus in 2009. That bender raised federal spending to a post-World War II record of 25% of GDP and it hasn't fallen below 24% since.
This was the liberal fiscal playbook in action, and we now see its economic results. The unemployment rate was supposed to be closer to 6% today, not 8.2%. The recovery in jobs, output and income is about half the strength of a normal recovery, according to Congress's Joint Economic Committee.
Instead of a positive multiplier from the spending, the impact was close to zero. Harvard's Robert Barro reports that in many cases the multiplier from government spending is less than 1.0, meaning that "greater spending tends to crowd out other components of GDP," mostly private investment.
Yet Mr. Bernanke parrots the tales of horror that are circulating on Wall Street and Washington about the savage impact of federal spending cuts. This turns economic history upside down. In the last 30 years, Congress has made two major efforts to reduce federal spending, and both times the economy performed well.

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Associated Press

Federal Reserve Board Chairman Ben Bernanke.

At Ronald Reagan's urging, Congress passed a spending cut in 1981 that (after the recession) began a slow decline in spending as a share of the economy over the 1980s. A decade of historic growth followed. In 1994 Republicans took over Congress, Bill Clinton declared "the era of big government is over," and spending was cut and began to fall as a share of GDP throughout the 1990s. The economy and stocks boomed, aided by a cut in the capital gains tax rate to 20% from 28%.
From 2000-2012, by contrast, federal spending has increased to 24% of GDP from 18.2%, and a durable recovery still hasn't arrived. Some government spending can be useful—aircraft carriers to win the Cold War or new roads—but overall it tends to be a net drag on growth. As Milton Friedman explained, a dollar spent today has to be paid for either now or later with a dollar of higher taxes. Friedman said one way to grow the economy faster is to cut spending as much as possible in the short term.
Meanwhile, the cliff that could break the economy's neck is the scheduled tax hikes. These include a tripling of the tax on dividends, a near 60% increase in the capital gains rate, a 20% increase in personal income-tax rates that will hit small businesses, and the repeal of tax breaks allowing businesses to write-off capital purchases. (See the nearby table for the comparisons.)
Even if the lower rates for those earning less than $200,000 are extended, the rise in rates for high-earners will hurt the incentive to invest or take risks—and may already be doing so. As Mr. Bernanke put it, "Uncertainty about the resolution of these fiscal issues could itself undermine business and household confidence."
After a five-year spending binge and $5 trillion in new debt, markets want to know if Washington can control its tax and spending appetites. Any such signal would be bullish for growth. In the faux debate between growth and austerity, the Keynesians have deliberately confused the terms. They want to impose austerity on the private economy with tax increases. But for the private economy to grow faster, we need austerity for the government.