The Cliff Hangs on the Fed: Why Ben Bernanke Controls the Economy's Fate

The liberal nightmare about the fiscal cliff is overwrought, since the Fed has the power to avert disaster. If Bernanke acts properly, Congress could cut spending deeply without risking a recession.



The economic stakes from the fiscal cliff debate aren't quite as high as you've been hearing. One largely unexamined assumption of the debate is that going over the cliff--that is, allowing the Bush tax cuts to expire on schedule and letting spending cuts Congress previously legislated take place--will push us into another recession in 2013.

It's a familiar Keynesian argument. Writing about the cliff, Paul Krugman warns that "bringing down the budget deficit when the economy is already depressed" would make "the depression deeper." IMF managing director Christine Lagarde has raised the same worry, citing forecasts of the cliff's effects that are themselves based on Keynesian assumptions. On those assumptions, spending cuts and tax increases depress the economy because they take money out of people's pockets. The affected people spend less money, the people who would have received their spending as income do the same, and pretty soon we are in another recession.

There are indeed reasons to fear falling off the cliff. Scheduled increases in taxes on capital formation, for example, would do long-term damage to the economy. The Keynesian nightmare about the cliff is overwrought, however, because the Federal Reserve has the power to avert it. For that matter, Congress could cut spending much more deeply than it is now considering without risking a recession -- at least if the Fed acts appropriately.

The point should be easy to grasp if you imagine a central bank that has a 2 percent inflation target that it hits every year. Under those circumstances, neither fiscal stimulus nor austerity can change levels of inflation or output. If a stimulus inflated the economy, the central bank would just deflate it again to hit its target. If austerity shrank the economy, the central bank would re-inflate it. The total amount of economic activity would not change (although how much of it was directed by private-sector actors would).

The same conclusion -- that changes in the federal budget position cannot affect the size of the economy overall -- follows if the central bank substitutes a nominal-spending target for an inflation target and hits it every year. In the real world, of course, central banks do not hit their targets perfectly. They do, however, have the power to come close, which means that fiscal policy cannot have a large effect if they are trying.

Keynesians sometimes concede this argument as a general matter but say that special circumstances can render central banks impotent and fiscal policy crucial. They have in mind a "liquidity trap" in which interest rates are too low for the central bank to reduce them any further. As Bentley University economist and blogger Scott Sumner likes to remark, however, there is no case in the history of the world in which a central bank in a fiat-money system has tried to inflate and failed. Ben Bernanke has never claimed that he might run out of ammunition either.

Presented by

Ramesh Ponnuru and David Beckworth

Ramesh Ponnuru is a senior editor at National Review, a columnist for Bloomberg View, and a visiting fellow at AEI. David Beckworth is an assistant professor of economics at Western Kentucky University and former economist at the U.S. Treasury Department. He is the editor of Boom and Bust Banking: The Causes and Cures of the Great Recession.

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