Monday, November 19, 2012

There Is No Fiscal Slope

Households and firms make economic decisions based on how they expect the future to unfold.  If households expect higher future incomes they are more likely to increase consumption spending today. Likewise, if firms expect higher future sales they are more likely to increase investment spending today. Economic expectations are therefore key to understanding current decisions about aggregate nominal spending. They are also why I think it is is a mistake to talk about a "fiscal slope" like this:
But there is not really any kind of “cliff” in the sense that if you stepped over the edge, you would fall fast, land on something hard, and not get up for a long time. In the modern US economy, the scheduled changes constitute more of a fiscal “slope” – meaning that the full effect of the tax increases would not be felt immediately (income withholding takes time to adjust), while the spending cuts would also be phased in (the government has some discretion regarding implementation). 
If households and firms expect the economy to get much worse because of this fiscal tightening--and they have no reason not to given all of media coverage--it does not matter that it is will unfold slowly over next year. They will change their behavior today in anticipation of this fiscal cliff and make it a self-fulfilling outcome.  So unless the Fed offsets the fiscal tightening, there is no fiscal slope.  It is a pipe dream.

This understanding may shed some light on recent developments in expected inflation that have folks like Ryan Avent worried. Expected inflation, as measured by treasury breakeven rates, during this crisis has been a good indicator of the market's economic outlook. Higher expected inflation implies higher future nominal spending. Given the current slack and nominal rigidities, higher expected nominal spending in turn implies higher future real economic growth. That is why the stock market has closely tracked this indicator over the crisis as seen below:


 But lately expected inflation has been falling.  Here is Ryan Avent:
[S]ince mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.
Avent goes on to speculate why expected inflation would be falling now. He cites as possible explanations an expected economic slowdown elsewhere in the world or the breakdown of the relationship between expected inflation and demand growth.  There is a third alternative: markets in mid-October began to price in the increasing likelihood of the fiscal cliff materializing since they realized President Obama was probably going to win reelection.  This fits nicely with the fact that the decline in expected inflation is being matched by a sustained fall in the stock market, indicating the relationship is still strong.  This can be seen in the figure above or in the close up below:


If this interpretations is correct, then it supports the view that it is a mistake to hope for a fiscal slope.  Expectations matter.

6 comments:

  1. "If households expect higher future incomes they are more likely to increase consumption spending today"

    Many households are cash constrained - they spend essentially all of their income (no savings) and have no real way of increasing income. They are not likely to increase consumption spending.

    For many others, the future is too uncertain to plan. We can never have any real assurance as to what future economic, tax, etc. conditions will be.

    A much publicized recommendation is for Obama to wait until early January to cut a deal, at which time his bargaining position improves. Households and firms could take this into account, lessening an cliff implications to New Years Day.

    I'm not saying expectations are unimportant, just that we have to be careful here.

    ReplyDelete
    Replies
    1. Foosion, the quote you mention is a hypothetical illustrating a point. Notice the sentence begins with "If".

      Delete
    2. His bargaining position ONLY improves if the next House Budget Resolution allows the reduction of taxes without offsets. This has been standard fare in the past, but Republicans are likely to accede to the years long demand - for the next budget resolution only - that tax reductions are offset dollar for dollar out of the discretionary accounts. Note: This will only occur if they do not reach a deal.

      For people to say this won't matter, and that the budget resolution is advisory only, I will note that the 302(b) allocations that the House Appropriations Committee uses are very real.

      I have worked in DC and on the Hill for over 20 years. Trust me when I say that Obama has much less leverage than thought if we go over the cliff. It's just that even most of the Members of Congress don't understand the budget rules and how they will apply.

      Delete
  2. I disagree. Expectations are based on now emotional conditions, not no conditions. In otherwords, US business is underinvesting to the point they can't for much longer or somebody is going to invest and make a TON of money at their expense.

    ReplyDelete
  3. I'm with foosion on this one. Anon - forget the "if." This entire post is based on that statement.

    What Prof Beckworth is saying is by-the-book econ. But what does it have to do with the real world? Stocks are owned by a small segment of the population.

    Easily 25% of the population - at the far end - lives hand to mouth, and perforce will spend the next available dollar on groceries, fast food or a new pair of underwear.

    They have no expectations, and never will, because they have no choice but to live in the moment. For my whole adult life, my spending decisions have been based on $$ in hand, not what I think i might be making a year from now.

    Joe Beer can, eyeing that big screen TV, is not thinking about the prospects of his next nickle raise. He's thinking about whether he can make the monthly payments and still afford to feed his cat.

    That's the difference between economics and the real world.

    I'm not saying expectations don't matter. For some people, they do. I'm saying that for a very large segment of the population they are at best a 4th decimal place consideration.

    And that is the segment of the population that economics fails to consider in its abstract models.

    JzB

    ReplyDelete
  4. So markets thought that a Romney victory would have avoided the fiscal cliff? Or was it more a question of the House Republicans?

    ReplyDelete