A funny thing happened to our dysfunctional government. It functioned, unwittingly perhaps, but function it did. President Obama forced Republicans, unwilling to risk the political consequences of taking America over the fiscal cliff, to accept a $180 billion tax increase. Republicans returned the favor by forcing the president to live with an across-the-board spending cut—the sequester—that he had long-ago proposed, confident that Congress would never implement it. He guessed wrong. As a result of these tax increases and spending cuts, our government’s deficit is headed down. It was $1.1 trillion in fiscal 2012, will be about $845 billion this year, and fall to $615 billion in fiscal 2014, almost half the amount of red ink spilled in 2012. The deficit-to-GDP ratio is also falling, from 7 percent in 2012 to 5 percent this fiscal year, and to a reasonably acceptable 3.7 percent in 2014. The Treasury actually will be paying down debt in this quarter. Yes, April is typically a month of high tax collections, and the Treasury will resume borrowing in the next quarter. Still, this is the first quarter since 2007 in which the Treasury will pay off at least a few of our IOUs.
Republicans are unhappy that this touch of fiscal sanity has been purchased at the price of substantial tax increases, Democrats that it has been bought by cutting some of their precious spending programs, voters that the President has ordered his bureaucrats to maximize the pain of spending cuts and that their pay checks have shriveled as a result of the increase in payroll taxes.
Economists are guessing that fiscal tightening will knock between 1 percent and 1.5 percent off growth this year. The president and his followers argue that fiscal tightening should have been postponed until the economic recovery is less fragile. There is some sense to that argument, at least theoretically. But conservatives respond that Democrats will never believe the recovery is robust enough to stop borrowing to fund an expanding state. So better to get the deficit under control now, even if the sequester is a clumsy paring instrument.
Two developments support the cut-the-deficit-now crowd. The first is Friday’s jobs report. The private sector created 176,000 new jobs in April, and the initially reported February and March figures for total jobs created were revised upward by a total of 114,000 jobs. The revised February figure of 332,000 was the highest in almost 13 years, if we ignore temporary blips such as the addition of thousands of census workers in 2010. Better still, the number of long-term unemployed (27 weeks or longer) declined by 258,000. Not all of the data buried in this detailed Labor Department report are as encouraging—hours worked continue to drop—but all in all it provides more talking points for the deficit hawks than for the deficit doves. The deficit is plunging, and the jobs market has not weakened, at least so far.
The second development that makes fiscal tightening less worrisome is the decision of the Federal Reserve Board’s monetary policy committee to ride once more unto the breach. It will not only continue the current loose policy, but if necessary loosen further. It emerged from its two-day policy meeting this week to announce, “The Committee is prepared [this is new] to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes [italics added by me].”
There is more. With the Fed’s preferred measure of inflation hovering at around 1 percent, inflation fears that might have worried the Fed have abated. In addition, the Fed will not slow the presses if the unemployment rate falls only because workers in greater numbers give up the job hunt—if the labor force participation rate declines further, in technical jargon. In short, tighter fiscal policy will be offset by continued loose, or even looser monetary policy. That means the age of near-zero interest rates is far from over. The result:
· Continued easy credit for car buyers—which re-employed and more fully employed construction workers are using to purchase new trucks.
· Continued record-low mortgage rates that are driving sales of houses—both sales and prices are rising, each up over 9 percent compared with last year.
· Continued rises in share prices, as traders add chairman Ben Bernanke to their pantheon of heroes.
High house prices combined with rising share prices create a wealth effect, boosting the consumer confidence index in April. Consumers seem to be reacting to the increase in payroll taxes by cutting savings rather than spending, at least so far.
The key role of the Fed focuses attention on just who will head that institution next year. Bernanke is passing the word that he has had enough. He will not attend the central bank summer conclave in Jackson Hole, Wyoming, the first time in 25 years that a Fed chairman has absented himself. And he told the press, “I don’t think I am the only person in the world who can manage the exit” from current policy. So come February 1, 2014 it is likely that there will be a new man at the helm, or woman.
If the Fed decides at some point in coming years to begin to unwind its positions, sell off its holdings of bonds and mortgages, that exit will have to be managed with considerable skill lest interest rates soar, the burden of federal and private debt becomes unbearable, the housing market collapses. Unless, of course, a Fed decision to pull back on its purchases of bonds and mortgages is taken as a signal that the recovery is robust and self-sustaining, that all is now well in this best of all possible economies.
It is most likely that the management of any exit will fall to Janet Yellen, Fed vice chair and formally president and CEO of the Federal Reserve Bank of San Francisco. Ms. Yellen’s critics fear that she will be insufficiently sensitive to the long-run inflationary effects of current policy, will wait too long to exit, and might even follow through on the Fed’s new announcement that it might increase bond and mortgage purchases. But even her critics agree with her more numerous admirers that she is extraordinarily well qualified to succeed Bernanke should he decide that a return to Princeton on January 31, 2014 is in his best interest or the president that it would be in the nation’s.