What to do about the Fiscal Cliff?

What is so interesting about fiscal policy? This week I learned how the federal government's fiscal
policies effect the macroeconomic model I talked about last week. This is the model that describes
the total output of the economy equaling the incomes of households, which is then "leaked"
through savings and taxes (adding the Government into the picture). The taxes are reinjected
through government spending, and the savings are used as investment by businesses, all of which is
added to consumption by households to equal aggregate demand.

So, in Norm's post this week on the looming "fiscal cliff" I think we can apply this new fiscal policy
lens. Norm is talking about an article from the New York Times by Paul Krugman which explore's
the upcoming automatic reduction in government spending and tax cuts which was agreed upon in
2011 in response to the debt ceiling discussion. In the article, Krugman argues that President
Obama should not allow the tax cuts for the wealthy to be exempted from the bill as the
Republican Party is pushing for. Norm notes that this will be hard to accomplish as Obama wants to
exempt the middle class tax cuts from the bill, which is what is allowing the Republicans to bid for
the wealthy tax cuts exemption. Krugman says that if Obama cannot exempt the middle class tax
cuts, then he should let the bill move forward and take effect as planned. Many argue that this would
throw us back into further recession.

So this change in fiscal policy would increase taxes and decrease government spending to reduce
the government debt. In our macroeconomic model, this would decrease aggregate demand overall,
thus slowing the recovery through a decrease in consumption of output which then decreases total
income to households. I would argue, after reading Richard Coo's comments on Japan's failed and
successful efforts to end their very similar recession of the late 90's, that we need to increase
government spending right now as the most effective means of increasing aggregate demand. We are
experiencing a "balance sheet recession" according to Koo, which means that even with interest
rates from the FED of 0%, companies are not able to create new jobs because they are stuck paying
down their debts (as their liabilities currently exceed their assets, this is a must). Also, because
government spending is much more direct and effective at increasing aggregate demand than is
cutting taxes, and has a higher economic multiplier effect, government spending is what we need.
We also learned that even increasing taxes while increasing government spending, increases
aggregate demand.

The most effective way out of this recession then, is to increase government spending both on
social programs to help the multitude currently in need, and on direct job creation programs. I
would also keep some attention paid to our issue of government debt by partially financing all of
this increased spending with the elimination of tax cuts on the wealthy and on capital gains. It was
the very wealthy which maneuvered the financial sector into the role of grand casino in the housing
boom which caused this recession in the first place, and made them large sums of money, which
were then taxed at a much lower than fair rate. Thus, financing the recovery with increased taxes
on those at the top, is the the least our country could do to even be allowed to speak the word
"justice" with any kind of authority again. This method would also be very effective since, as I
discussed last week, tax cuts for the wealthy really have not led to faster or better economic
growth ever in our history.

I want to end by throwing in another little snip-it of reality which complicates our economic
models and is painfully absent from mainstream discourse. I was just reading a report from the New
Economics Foundation called, "The Economics of Oil Dependence: A Glass Ceiling to Recovery."
This report discusses the link between the rapidly decreasing stock of the finite resource we are so
heavily dependent on in the U.S. and the global recession. They define Economic Peak Oil as, "The
point at which the cost of incremental supply exceeds the price economies can pay without
significantly disrupting economic activity at a given point in time." This concept is very important as
all data point to us reaching Economic Peak Oil around 2014-2015. This is due to the complete lack
of new sources of crude oil in general, and in terms of low cost sources--as is evident by the recent
scaling up of oil extraction from the Alberta Tar Sands and subsequent need for the new Keystone
pipeline, which is a highly inefficient and costly source of oil. Technology only increases our usage
efficiency of oil products by 2-3% per year, a snails pace compared to the speed at which global
consumption of oil is increasing.

I bring this into the discussion not just because it is not being talked about, but also because we
have an opportunity to make a significant and lasting recovery effort. If we did increase government
spending, financed in part by allowing tax cuts on the wealthy to expire, and directed it all to a
Citizen Conservation Corps style jobs program focused entirely on the creation and
implementation of green energy projects, then we would be doing something more impactful and
worthwhile for future generations than simply reducing government debt.