The Fiscal Cliff and the Fiscal Multiplier

 | Nov 20, 2012 | 4:00 PM EST
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Shortly after the fiscal budget crisis that resulted in the Budget Control Act of 2011, I wrote about the fiscal multiplier. The act was the compromise between Republicans and Democrats to get a federal budget passed for fiscal year 2012, but it set up the conditions for this year's fiscal cliff -- tax increases and spending cuts that go into effect Jan. 1, 2013. Neither party wants to see this.

The idea was that both parties in Congress would get together with the executive branch and work out a federal budget that would be less strict than what the Budget Control Act requires. Unfortunately, this never happened because 2012 was also an election year and both parties found themselves falling back on their respective ideologies to appease core constituencies.

Instead of using the past year to draft a budget that would allow for an increase in fiscal spending and a decrease in marginal income tax rates by focusing the federal budget on a higher fiscal multiplier, the budget was essentially left with the same negative multiplier expenditures that have marked the Obama administration since 2009.

The principal problem facing the federal government now is exactly the same as it was last year and has been since the crisis of 2008: How to get economic returns on federal spending to be greater than the expenditures themselves. Unless this happens, the increase in income tax revenue caused by a more progressive tax structure will be nullified by the continuing negative multiplier of federal spending, with a net result of a negative impact on aggregate economic activity and an even higher federal debt and deficit in the years to follow.

With the U.S. debt to GDP and debt service as a percentage of tax revenue getting very close to the terminal state of being irreversible, the current fiscal situation is actually far more serious than most politicians will discuss publicly. The estimated limit of sovereign debt to GDP that a country can achieve without eventually requiring insolvency is about 150%. The terminal limit for sovereign debt service as a percentage of tax receipts is about 25%. On the current trajectory, the U.S. will exceed both these levels before President Obama's second term is completed. If that happens, the U.S. will be on a terminal path to sovereign insolvency. All that will be left for the bond vigilantes to do is time the acknowledgment of this inevitability.

The only way to avoid this scenario is for the executive and legislative branches to focus on an increased fiscal multiplier. Although there is a great debate about how to best cause the multiplier to increase into positive territory, the best hope for doing so is to focus federal spending on infrastructure. If an infrastructure program is not pursued, investors should watch for at least a public discussion by policymakers for the necessity of an increased fiscal multiplier.

If neither occurs before the end of 2013, the probability of the U.S. reaching a terminal insolvency trajectory will increase quickly, and could become self-fulfilling within the next few years.

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