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.
The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.
Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.
The U.S. economy over the past two years has exhibited the same pattern. Since mid-2010, total federal expenditures, measured in dollars, have trended down. The budget deficit as a share of the economy has fallen more than 2 percent over this time. This fiscal tightening has taken place in the midst of a barrage of economic shocks including the Eurozone crisis, the 2011 debt ceiling talks, and concerns about an Asian economic slowdown that have kept economic uncertainty elevated. Yet nominal spending has been incredibly stable, growing at about 4.5 percent a year. The recovery has been sluggish, but the Fed appears to have kept fiscal contraction and other economic shocks from ending it.
It could counteract the effects of the fiscal cliff, too. The Fed could best do this by explicitly adopting a nominal-spending target. The more credible that target, the less the Fed would have to do to reach it: Private-sector expectations of future spending powerfully influence current spending levels. Knowing that the Fed would do whatever it takes, including aggressive open market operations, to maintain steady nominal GDP growth would create confidence and more economic certainty for households and firms -- regardless of whether the government was cutting spending. The effect should be to offset every dollar of reduced government spending by roughly a dollar of increased private spending.
The Fed cannot undo the effects of any bad policy Congress enacts: It can't, for example, restore incentives to work, save, and invest if legislators stifle them. What the Fed does have the power to do is to keep the Keynesian nightmare from taking place. We might fall off the fiscal cliff and then go into a recession. But if we do, it will be because the Fed failed to do its duty.