13 December 2012

Bernanke Offers a Solution to the Fiscal Cliff (or, the real lesson from Spain and Greece)

Federal Reserve Chairman Ben Bernanke offered a simple solution to the deficit problem: wait until unemployment drops to 6.5% before enacting measures to raise taxes and cut spending.

Bernanke actually announced that his monetary policy would continue to stimulate recovery until unemployment drops to 6.5% or inflation rises to 2.5%. There is no reason that similar guidelines could not be used for fiscal policy as well, though.

Analysts are forecasting how many jobs will be lost if automatic tax hikes and spending cuts are triggered in January. It could cost as many jobs as we've gained since the bottom of the Great Recession. This is not because deficit reduction will always cost us jobs. This is because deficit reduction will cost us jobs when unemployment is still high. Using a guideline like Bernanke's for fiscal policy would change that.

The real lesson from Greece and Spain is simple: if you spend like drunken sailors on shore leave during good times and then sober up to begin cutting spending when times are hard, you'll first create a bubble and then a collapse. This is the worst possible combination.

Job losses from some combination of tax hikes and spending cuts are inevitable. What is not inevitable is that these job losses will matter terribly much. If unemployment is at 4.5% and we're creating 200,000 jobs a month, the job losses from deficit reduction will neither be hard to offset nor particularly hard on the economy. Timed properly, the tax hikes and spending cuts might actually shed jobs at about the rate that the economy is creating them. That's possible. Deficit reduction now when unemployment is at 7.7% and we're creating about 150,000 jobs a month could, by contrast, easily tip us into recession and cause unnecessary hardship.

We needn't force a trade off between deficit reduction and another recession if we simply wait. There is no reason that fiscal policy could not follow the same guidelines that Bernanke just laid out for monetary policy.

But there is a deeper problem. We live in a time of incredible potential and great risks and yet our epitaph will be that in face of all that we were re-hashing arguments from Economics 101 and second grade arithmetic. This fact is more worrisome than any short term deficit or recession. It's as if you still have to tell your teenager to brush his teeth. Ridiculous.

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