CEPR - Center for Economic and Policy Research


En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press It's So Cute When People Who Couldn't See an $8 Trillion Housing Bubble Tell Us How Markets Will React to the Ending of the Bush Tax Cuts

It's So Cute When People Who Couldn't See an $8 Trillion Housing Bubble Tell Us How Markets Will React to the Ending of the Bush Tax Cuts

Wednesday, 14 November 2012 02:24

The Washington Post has been as aggressive as any Republican in Congress in hyping the dangers of letting the Bush tax cuts expire. It has run numerous front page pieces telling readers of the dire consequences of letting January 1 pass without a deal (e.g. here and here). Today Wonkblog warned of us the real bad news of going off the fiscal cliff!!!!!!!

Just in case you didn't understand the Post's official line on this, the headline of the piece is "the economy (probably) can't survive a short dive into austerity crisis." It starts with some clearly mistaken economics. It calculates the hit to the economy of higher tax with-holdings for the month of January.

"In a narrow sense, a short voyage off the cliff shouldn’t crush the economy too badly. The CBO estimates that the full brunt of the policies add up to about $56 billion a month, which is a lot of money — about 4 percent of GDP — but should, in theory at least, do only modest damage to the economy if it lasted only a few weeks. One month of austerity along those lines would subtract only about a third of a percentage point from growth for the full year, before accounting for multiplier effects.

For comparison, the U.S. economy grew at a 1.8 percent rate over the last year; if a single month of fiscal cliff-style austerity had been in place, that number would have been more like 1.4 percent."

The problem with this arithmetic is that consumption is unlikely to respond in any measurable way to a one-month tax hike. There is a big debate among economists as to how much consumption responds to temporary tax cuts, like the Make Work Pay tax cut that was part of the initial stimulus package. Many economists, especially those who seem to be most worried about the "fiscal cliff" right now, argue that consumption responds little or not at all to tax cuts that are scheduled to be in effect for a year or two. One doesn't have to agree with this strong position to accept the view that a one month increase in taxes will have a minimal impact on people's consumption patterns.

This is especially likely if the tax increase is likely to be reversed the next month, which would almost certainly be the case, as the column acknowledges in the next sentence. So, this arithmetic exercise gets us essential zero hit from jumping over the fiscal cliff.

But wait there's more:

"But all this seems like a naïve way of viewing the situation, one divorced from the real ways that markets and psychology interact with economic forces."

Okay, economic reality is "naive," now we will get the Post telling us whatever it goddamn pleases under the guise of market psychology and trying to convince readers it is talking about the real world.

Here we go plunging into WAPO psycho-economicsland:

"There are plenty of actors in the economy who either haven’t followed the buildup to the fiscal cliff at all or have done so with only a wary eye and crossed fingers. In a slew of corporate earnings conference calls in recent weeks, executives of major companies have mentioned the fiscal cliff as one of the many looming threats, but rarely offered comments more detailed than 'we hope and expect that the politicians will solve it.'

'As we consider 2013 today, let us assume that a solution to the fiscal cliff will be found,' said Arne Sorenson, chief executive of Marriott International, in its earnings call last month.

"It is easy to imagine that if there is no solution, the Sorensons of the world will reconsider their own capital spending and hiring plans; even a few weeks in which Washington allows dramatically tighter fiscal policy could lead to a haze of uncertainty and delay as that basic assumption — that at the end of the day, after all the sturm und drang, the politicians will deliver a compromise — proves untrue."

Get that, "it is easy to imagine" line? I suppose in WAPO land it is easy to imagine lots of things.

But lets instead imagine that the Sorensons of the world are sober businesspeople who have some grasp of reality and can do things like, well, read newspapers. They might be disappointed to find out on January 1 that there is no deal, but they would likely see the New Year's Day paper filled with articles that have quotes from President Obama, Speaker Boehner and the rest of the gang telling us how they are going to resolve this dispute and that they are close to reaching a deal. In this case, they would probably continue with their business as though a deal is about to be reached, which everyone (including the Post) agrees is true.

Okay, but we are not out of the woods yet.

"Financial markets, if the past is a guide, will only reinforce these trends. When Standard & Poor’s downgraded the U.S. government’s credit rating in August 2011, citing a dysfunctional process for resolving the debt ceiling standoff (a deal that set the stage for the current negotiations), there was no apparent damage to the government’s finances — borrowing costs actually fell — but plenty of extra volatility in world financial markets.

"Markets don’t like risk. And for the world’s largest economy to adopt a yo-yo approach to fiscal policy — steep tax increases and spending cuts one month, a reversal the next — would be an extra layer of risk for already jittery markets. A falling stock market hammers both households’ wealth and confidence and businesses’ willingness to invest.

"Who knows if a few weeks of austerity would cause a recession or merely a soft patch in growth. But with unemployment at 7.9 percent, neither is particularly welcome. 'I don’t know whether reversing this in a few weeks would turn the business cycle around like turning on a switch,' said Feroli, 'but it seems like losing this gamble would be very costly for everybody [Feroli is Michael Feroli, chief U.S. economist at J.P. Morgan Chase].'"

Okay, so now we have the Post telling us that it knows how the financial markets will react -- and they have the chief economist at J.P. Morgan to back them up. Of course they could be wrong, as they acknowledge, but we better not risk it.

There are three points here. The first is the usual one: "if you're so smart, how come you're not rich?"

The WAPO doesn't know how financial markets will react, they are guessing. Financial markets act in crazy ways in response to all sorts of things. The huge stock market crash of 1987 was not traceable to any obvious set of economic events. Apparently the Post is unaware of it, but the volatility in financial markets in August of 2011 was likely due to Italy joining the list of euro crisis countries as interest rates on its bonds soared. (It's hard to get news about Europe in Washington.) Interest rates on U.S. Treasury bonds plummeted. That is not the reaction that one typically expects from a downgrade.

The second point is that the impact of short-term gyrations in financial markets is minimal. A stock market that falls for a week or two will have minimal effects on consumer and business spending. (The stock market generally has minimal impact on business spending, contrary to media hype on this topic.) Presumably any slump from over-reacting markets will be reversed when Congress and the president sign a deal. Even the crash in 1987 barely impacted growth. The economy grew at a 7.0 percent annual rate in the fourth quarter of 1987.

Okay, but why take any risk at all, after all the economy is weak, as everyone agrees. There are two points to be made here. First, the economy is weak. So why are the serious people at the Post and in Washington obsessed with deficit reduction? The interest burden of the government debt is near a post-war low. It seems really silly for the government to be focused on deficit reduction at all right now, as Mr. Feroli's comments would seem to imply.


Source: Bureau of Economic Analysis.

The second point is that there is a reason to take a risk, which seems minimal when we focus on the evidence rather the things that are "easy to imagine" at the Post. The issue is more than $700 billion in tax revenue from rich people over the next decade. If the rich don't pay it, the rest of us will, since it is unlikely that we will get the folks in Congress to raise their deficit targets by this amount.

So the question boils down to whether the rest of us want to lose $700 billion in taxes or from programs that benefit the middle class, like Social Security and Medicare, or do we want to take the Post's imaginary risks associated with letting the tax cuts expire. The choice is yours, America!

Comments (18)Add Comment
written by foosion, November 14, 2012 5:16
The Center for American Progress has a plan to save $385 billion from Medicare. http://www.americanprogress.or...tion-plan/ News stories report it as a plan backed by the administration.

That's more than half of the $700 billion
Fiscal Cliff is death knell for Norquist Pledge
written by Robert Salzberg, November 14, 2012 5:20
Missing from the WonkBlog piece is any mention of the critical component of the debate which was reported earlier that morning in The Hill and also in WaPo an hour earlier on Greg Sargent's blog. Grover Norquist has lost both a majority in the House and is down to 39 votes in the Senate.

As the deadline approaches, it is inevitable that even the mainstream press will begin pointing out that only adherence to the pledge and/or an ideology that says you can't raise net taxes ever, ever, ever is preventing Republicans from raising taxes on the rich.

Since Democratic Congressional leaders have also indicated that a resolution to the debt ceiling will also be folded into negotiations about the 'fiscal cliff', a teachable moment is taking form.

Our current House of Representatives will be remembered in history as the only one that threatened the full faith and credit of America by not agreeing to pay for bills it created and for raising taxes on everyone as a matter of principle, the principle being to never raise taxes on anyone.

Americans should be looking forward to celebrating an end to our collective alternate reality nightmare on New Years Eve.

Billionaire's Tax
written by Robert Salzberg, November 14, 2012 5:27
Financial markets are supposed to be a reflection about what reality will be like 6 months or so in the future and so ending the Bush Tax cuts on the wealthiest Americans should already be baked in.

The real question is when will the billionaire hedge fund managers lose their prized carried interest loophole.

President Obama and Democrats have talked a lot about millionaires.

I'm looking forward to the talk about the Billionaire Tax.
The Russians Are Coming, The Russians Are Coming
written by Last Mover, November 14, 2012 5:42
Seems Mitt Romney is still feeding the media fears we're all gonna die from cold war cliffs.
End of the insurrection
written by Ryan, November 14, 2012 7:18
I read that piece and had numerous problems, and a few questions, so thank you for providing a very detailed explanation. My takeaway at the end though was that Klein's insurrection has been killed by the editors. At least now he can join MSNBC I guess.
Good Analysis by a Republican on Fiscal Cliff
written by Robert Salzberg, November 14, 2012 7:36
Good Argument for Radical Tax Reform
written by Robert Salzberg, November 14, 2012 7:53
written by MacCruiskeen, November 14, 2012 8:50
It's so cute when Dean Baker gratuitously reminds us of his amazing call on the housing bubble (i.e., the thing that nearly everyone who wasn't an economist could see). Not that he's proud of it or anything.
written by skeptonomist, November 14, 2012 8:55
One thing which does respond rapidly to tax-rate changes is capital gains. If investors really believed that capital-gains rates were going to go back up permanently to pre-Bush level they would be selling off to take advantage of current rates. This would not necessarily result in a stock-market crash because they could immediately reinvest (although they might try to hold off and take advantage of a dip in prices), but could cause a spike in capital-gains tax revenue. This is just what happened before the higher rates of the 1986 tax bill went into effect:


data from the IRS). If investors really distrust Obama's economic policies as much as claimed by Romney and Republicans, that gives them more reason to dump stocks and cash in after a good bull market since 2009.
written by JSeydl, November 14, 2012 9:05
the volatility in financial markets in August of 2011 was likely due to Italy joining the list of euro crisis countries as interest rates on its bonds soared.

I'd also add that on the day of the downgrade, there were some pretty substantial downward revisions to Q2 and Q1 GDP growth, which also likely freaked out investors a bit.
written by skeptonomist, November 14, 2012 9:26
One things which should be emphasized, as long as we're conjecturing about incentives, is that if Obama and Democrats give in to Republicans on the threat to hold the economy hostage at the end of the year, that gives Republicans more incentive to repeat the performance to get yet more tax cuts for rich people in the future. The next opportunity comes early in 2013 with the formerly automatic vote to extend the debt ceiling.
written by Bloix, November 14, 2012 9:50
"It's so cute when Dean Baker gratuitously reminds us of his amazing call on the housing bubble (i.e., the thing that nearly everyone who wasn't an economist could see)"

Maybe you saw it, but the Washington Post didn't.

Actually Dean is being overly polite here. The real point is that people who made a lot of money from not seeing what was in front of their faces are now trying to make a lot of money from seeing something that isn't there.
written by liberal, November 14, 2012 2:43
MacCruiskeen wrote,
...the thing that nearly everyone who wasn't an economist could see...

True, economists as a class are woefully corrupt, but how many non-economists called the housing bubble as early as Dean did (2002 IIRC)?
Wasnot teh
written by Floccina, November 14, 2012 3:03
It's So Cute When People Who Couldn't See an $8 Trillion Housing Bubble Tell Us How Markets Will React to the Ending of the Bush Tax Cuts

Very true but I have begun to wonder if maybe it was Basel III that caused most of the collapse in the home prices and the economy. The sub-prime market was not that big.
Irwin vs Klein?
written by William Berkson, November 14, 2012 7:20
Ryan, do you know something the rest of us don't? Ezra Klein just proudly announced Irwin coming on board his WonkBlog. I was really wondering about this first post; Baker's version here seems more plausible. Was there really a bust up over it?
"Fiscal" "Cliff"
written by John Street, November 15, 2012 10:06
I wish we would stop using that term.
written by liberal, November 15, 2012 2:03
Floccina wrote,
The sub-prime market was not that big.

But it was the entire thing that cratered, not just sub-prime.
written by Buck, November 15, 2012 10:34
I posted this article on Reddit and got 600 comments, unfortunately most of them amount to "RON PAUL SAW IT!".


Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.


Support this blog, donate
Combined Federal Campaign #79613

About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.