The solution to the problem of the "Fiscal Cliff" is simple: Nominal GDP level targeting. The reallocations of resources made necessary by the increases in taxes and reductions in military and nonmilitary discretionary spending would occur in the context of expectations of growing spending on output. To the degree that the reallocation of resources temporarily reduces output, those sectors of the economy where demand will increase can expect rising prices and higher profits.
Unfortunately, the Fed remains wed to interest rate and inflation targeting. A decrease in the budget deficit is an increase in national saving. Other things being equal, the natural interest rate falls. This brings investment and national savings back into equilibrium. This would occur by a decrease in the quantity of private saving supplied--more spending on consumer goods and services and an increase in the quantity of investment demanded--more spending on capital goods. Since the higher taxes will tend to depress spending on both consumer and capital goods, much of this adjustment is simply a reallocation of private expenditure. Still, total private spending of some sort needs to expand to offset the reduced spending on government goods and services.
With the Fed's preferred interest rate target already very low, the Fed cannot make what would be a qualitatively correct response--lower the target interest rate. The Fed, presumably, will continue to flail around, perhaps expanding its asset purchasing program. That would also be the qualitatively correct approach.
As for inflation targeting, this implies that the competition of those losing employment in the government must slow wage increases for those who continue to be employed. This will slow wage increases, and expand profits in those sectors of the economy with growing demand. This should result in increased hires in those sectors. This process appears to be remarkably slow and ineffective lately.
So, if the Fed continues witn interest rate and inflation targeting, the "Fiscal Cliff" will cause problems. With nominal GDP level targeting, these problems are less severe.
Of course, the "Fiscal Cliff" has other implications as well. It isn't just about spending on output.
The end of the Bush tax cuts and increase in every one's marginal tax rates is undesirable. Still, these things should be kept in perspective. In 1980, the top marginal tax rate was 70 percent. And while I did support the Bush tax cuts, I certainly considered it a less than ideal approach. Rather than across the board cuts in marginal tax rates, I favor the choice of a low flat tax
Also, the Bush tax cuts were not implemented with a program of government spending cuts, but rather where implemented along with big government Republicanism--an orgy of government spending. The reason the tax cuts had a 10 year time limit was that the positive impact on the tax base of the lower marginal rates, as well as restraint in government spending, would result in lower budget deficits. That failed. Budget deficits are vast.
And so, my view is that across the board cuts in tax rates are better than nothing, (though much worse than a complete tax overhaul,) but any such tax cuts should be combined with a program of smaller government--reduced government spending. This is the deal for voters--you have to give up government benefits to get lower taxes. And, of course, you have to put up with higher taxes to get more government benefits.
And so, we are back where we were in the early part of the 21st century. Back to the drawing board.