When Federal Reserve Chairman Ben Bernanke coined the phrase fiscal cliff nearly a year ago, the danger he saw was the recessionary effect of cutting spending and increasing taxes too drastically.
So it is ironic that all the debate lately has been over the relative size of decreases in spending trends versus tax increases. No one seems to be discussing how much overall belt-tightening is best right now.
But we are going to be affected by the degree of fiscal austerity we decide on, whether we address it openly or not. So it would be good to understand it.
It is useful to start with the simple equation for Gross Domestic Product that students studying introductory macroeconomics must learn. GDP is a measure of the dollar value of output. In itself, it is not a measure of the well-being of society, for a variety of reasons. But GDP does determine national income, and thus the household income that is available to people.
Although GDP is tabulated quarterly, the value given, such as the $15.8 trillion for July-September 2012, is the amount it would be if output continued at that rate for an entire year. News reports tend to focus on the rate of change of GDP rather than its absolute level. This is also expressed as an annual percentage rate.
Put another way, if we go into a recession, which means that GDP drops for two or more successive calendar quarters, someone will have less income available to buy goods and services. It may be people with less work or none at all, or it may be in the form of reduced business profits.
GDP measures the value of all final goods and services. In other words, it avoids double counting. If a family buys a loaf of bread, the value of the bread is counted, but not also the flour, yeast and oven used to make it, nor the wheat that went into the flour nor the seed, fertilizer and diesel fuel used to grow the wheat. These are intermediate goods or raw materials.
GDP consists of four components. Students memorize a little formula that GDP equals consumption plus gross investment plus government spending plus net exports. This is an accounting identity, not a theory.
Consumption is the using up of final goods like food, clothing, health care and recreational services, personal transportation, and so forth. In other words, it is most household spending on goods and services. Consumption is by far the largest category in GDP, typically making up over two-thirds of the total.
The investment in gross investment is not what most lay people would think. It is not buying stocks and bonds or other financial securities. Rather, it is used in the economists sense of new physical capital the tools, factories, offices, stores, industrial infrastructure and other long-term items used to produce more goods and services. In a modern knowledge-based economy, it may also include new software, or the design of a new drug, pacemaker or turbocharger.
Investment is gross when it counts the dollar value of new locomotives, dairy barns, business software or technological design without making any allowance for depreciation, the decline in value of existing locomotives, barns and software due to wear and tear or obsolescence. Make that adjustment and you have net investment and net national product.
Consumption and gross investment are valued at market prices. But many goods and services produced by government dont have market prices. What is the value of national defense or police and fire protection or a tornado warning? So the government component of GDP simply counts up the value of money spent. We dont place a value on children educated; we just add up teachers salaries, utilities bills for schools, consumable supplies, payments made to school bus operators and so forth.
It is important to understand that government in GDP tabulation does not include transfer payments, as when money from taxpayers is given to farmers in the form of crop subsidies or when FICA withholdings from workers salaries go to someone on Social Security. It is only that fraction of government spending going to produce goods, like public roads or warships, or services like education.
The final category, net exports, is the value of goods and services exported minus the value of goods and services imported. If we import more than we export, as we have over the past four decades, then net exports are negative.
Now, what does this have to do with the fiscal cliff? The implication of the GDP formula just explained is that if one component, say consumption, drops, then one of the remaining elements must go up or total GDP drops. And since GDP determines national income, someones income must go down.
Over the past five years, consumption has dropped as households bought smaller dollar amounts of goods and services because they wanted to pay down debt instead. This deleveraging was necessary because some households had been consuming at an unsustainable rate made possible only by taking on more debt. Many did this because the rising value of their houses made their net worth look good even if they ran up credit card debt or took out home-equity loans.
Falling consumption need not hurt total output and income if something else goes up. Net exports did to a small extent, since lower household spending meant fewer imports of consumer goods. Net exports thus became somewhat less negative in the GDP tabulation.
Falling consumption might also be offset by increased investment. Unfortunately, when households spend less, demand for goods and services falls and businesses invest less in new facilities and machinery. Yes, if the central bank makes interest rates fall, buying a new bulldozer or opening a new store is easier to finance. But if demand for new house lots or consumer goods is slack, then earthmoving contractors or retailers wont want to plow money into bulldozers or buildings that will be unused and unable to pay for themselves.
Hence, the logic that, as private consumption and investment fall, increased government spending on goods and services can keep total output, and hence national income, from falling as the private sector adjusts to new conditions.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at email@example.com.