A Fiscal Cliff with a Financial Trampoline

By Prof. Gerald Epstein, UMass. Economics Dept. & Co-director, PERI
(Excerpted from CPE’s Fall Newsletter), December 2012

Last year, President Obama boxed himself into a corner…almost. During negotiations with the Republicans in control of the House of Representatives, he agreed to back himself —and the US Economy—up against a “fiscal cliff” that required an agreement on a new budget after the election but before January 1, 2013, or face automatic tax increases, and spending cuts that not only could send the US economy into a recession, but that could also imperil social programs. Still, the typical Republican constituencies might have even more on the table: on the chopping block are Pentagon budgets and the wallets of the very rich, with automatic increases on the wealthy destined to go into effect.

In this scenario, the big danger is that President Obama might try to strike a “grand bargain”, like he tried to do in the summer of 2011, in which he trades away key benefits by weakening Social Security or Medicare in order to reach a budget deal. This time, a number of economists and political leaders have called on President Obama to walk off the cliff, rather than be pushed into a bad bargain.

The Congressional Budget Office has predicted that this approach might create a new recession, raising the unemployment rate back up above 9% (CBO: An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022http://www.cbo.gov/publication/43539 ).

Such a massive fiscal contraction could have very serious negative effects on workers and communities if nothing else were done. At the same time, this approach would have some benefits: it would cut military spending dramatically, and significantly raise taxes on the wealthy.  And, the strategizing goes, after January 20, 2013, President Obama could then propose tax cuts just for the poor and middle class which the Republican House might find politically difficult to oppose. This could help catch the economy as it was falling off the cliff.

In addition, these “cliff jumping” nightmare scenarios forget that there is another institution making macroeconomic policy: The Federal Reserve. The Fed has been keeping short term interest rates near zero for several years and plans to continue doing so for the next few years. This zero interest policy would continue to provide some cushion beneath a massive free fall from the cliff, but the Fed should do much more. The problem is that, so far, their near zero interest rate policy (sometimes called Quantitative Easing (QE) ) has not been terribly effective in restoring economic growth.

The reasons the QEs are not having a larger effect are many and can be divided into demand-side factors and supply-side ones. On the demand side problem is the classic “pushing on a string” problem. Too few firms have profitable expansion opportunities given the short-fall in aggregate demand. So they either do not want to borrow, or appear too risky to banks to justify lending to them.

But there is another side to the problem:  the financial intermediation system is broken.

This has a number of dimensions. One is that many large banks still have toxic assets left over from the financial bubble and  crash; this toxic over-hang leads banks to hold on to excess cash to cover law-suits, write downs, and fines to angry borrowers and government investigators, timid as they may seem. All told, US banks are holding almost $1.6 trillion in excess reserves. Robert Pollin estimates that as much as 600 billion might be precautionary holdings for these types of possibilities.

Another key factor is that the large Wall Street banks have so much market power, that they are using the Fed’s low interest rate policy to pocket vast quantities of profits by borrowing at low interest rates, and then refusing to pass on the savings to borrowers.

Progressive economists have developed important proposals to transform monetary policy to make it more effective. Robert Pollin in a series of papers proposes a carrot and stick: tax excess bank reserves to induce banks to lend out more, while providing government loan guarantees for loans to small business to induce banks to lend more.

But, there also needs to be more direct action. With the banking system so broken, there also has to be direct action to help debtors – home owners and students – to by-pass the broken banking system all together.  Senator Jeff Merkely of Oregon has proposed, for example, a fund to buy-up mortgages that middle class and poor homeowners can’t afford to service, and reduce the debt to manageable levels. This is modeled on the Depression era Home Owners Loan Corporation that was highly successful in keeping families in their homes. The Fed could support a program like this by buying the bonds issued by the fund, reducing the costs of running the program.

It is this kind of direct intervention by the Fed, bypassing the broken and overly concentrated banking system, and offering targeted lending to directly helphouseholds and students who are facing massive debt over-hangs, that could help transform weak monetary policy into a “bottom-up economic recovery”. This type of monetary policy and debt restructuring could place a “trampoline” for the economy under the fiscal cliff.

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