From a small northwestern observatory…

Happy New Year! It’s been a very busy month, evidenced by the lack of blog posts the past few weeks. The holidays, coupled with a mind-numbing travel schedule (and a broken lap-top! This is a new one!) kept me off the internet more than usual. In fact, I’m writing this from my hotel room in Charleston, SC, where Lynnda and I go every year to join our great friends and extended, adopted family at Renaissance Weekend.

As an economist, I’m terrifically concerned with the Fiscal Cliff.  I know it has dominated the media the past few weeks, and should certainly be on the minds of every thinking person, both in American and abroad.  As I write this, the Senate has apparently passed some stop-gap measures which now require action by the House. (As one participant here at Renaissance put it — “They didn’t just kick the can down the road, they kicked the whole store.”)   Nonetheless, as serious as everyone (except, apparently, Congress) realizes it is, I’m afraid that most folks probably don’t fully understand how bad it really can become.  Perhaps I can illustrate. 

I think most folks would agree that government spending at all levels must be reigned in.  The exact mix of cuts and taxes will differ between those on the left and those on the right, but all agree that the Federal deficit (both funded and unfunded liabilities) can’t go on at these levels for much longer.  However, some politicians — who apparently flunked Econ 101 — think that the best way to cure the problem is to let the car drive off the Fiscal Cliff.  They would use the analogy of a spend-thrift prodigal child, who needs “tough love” by simply being cut off from Mom and Dad’s largess.

Economists, on the other hand, see two outcomes from this, both of which will almost certainly happen, and both of which are devastating.  First, any system which is “shocked” will react in uncertain but probably negative ways.  Markets and market participants loathe uncertainty, and we can already see pull-backs in durable goods and investments as both businesses and consumers demonstrate a liquidity preference in anticipation of the anticipated meltdown.  The better analogy is like stopping or slowing a car — you can do it two ways.  First, you can apply a slow and steady braking (the way they taught you in Drivers Ed), maintaining control of the vehicle until the car comes down to the desired speed or until it stops completely.  Alternatively, you can drive head-long into a brick wall.  Pretty much everyone can guess what happens under the second alternative, which makes Fiscal Cliff seem to be a very apt descriptor.

The second outcome — which is the least understood by the layperson, and is surprisingly poorly understood by public policy “types” — derives from the secondary and tertiary impacts.  Imagine, if you will, a small town which is dependent on a factory for its “base” employment.  The factory suddenly transfers a significant portion of its workforce and production to another plant many miles away.  Those workers had been spending their paychecks locally, for groceries, haircuts, dental services, and the like.  The plant had been buying local supplies, such as fuel, tools, and repair services.  The loss of these ancillary benefits reverberate through the local economy, and are called “secondary” losses.  Now, the grocer, the barber, and the dentist can no longer pay THEIR bills, and these are “tertiary” losses.

With the advent of the Fiscal Cliff, very sudden secondary and tertiary impacts will be felt throughout the economy.  Lockheed, for example, will suddenly be told that certain  Federal contracts will no longer be honored.  They will lay-off tens of thousands of employees, who in turn will — ironically — look for welfare and unemployment assistance and will no longer pay taxes.  These employees and Lockheed itself, for example, will quit buying things, and the list goes on. 

Of course, the Devil is in the Details, as they say, and the exact set of ramifications won’t be known until payroll taxes go up, layoff notices go out, and certain government services cease.  I would fully agree — and encourage — that our Federal government needs to be re-sized.  Liberals and Conservatives may disagree on the exact degree of re-sizing, the appropriate mix of revenue and expense cuts to get to that new size, and the “things” which constitute necessary and fundamental government services.  Indeed, this re-sizing and realignment should be the central theme of President Obama’s second term.  I would posit that all of the other good things he wants to accomplish will be enabled by that sort of transformation.  Nonetheless, driving the economy over a cliff is not the way for Congress to provide us with the leadership that we pay them to provide.