EXCLUSIVE: Former Romney Advisor John Taylor on the Fiscal Cliff

We're three weeks away from the fiscal cliff -- a $600 billion combination of tax hikes and spending cuts Congress and the president are scrambling to avoid.

Last week, I sat down with Stanford economist John Taylor, a man with deep experience in both politics and economics.

Taylor served as undersecretary of the Treasury for International Affairs under president George W. Bush, and was recently an economic advisor to Mitt Romney. He's also one of the most influential monetary-policy economists in history (and is the name behind the Taylor Rule, for all you economics wonks).

I asked Taylor what he thinks about the cliff, and what will happen to the economy if we go over. Here's what he had to say (transcript below).

Morgan Housel: What's your take on the overall situation and what outcome would you like to see happen from the fiscal cliff?

John Taylor: First thing I always say about the fiscal cliff is, remember, it didn't come from outer space; it wasn't aliens that brought this. It was created in Washington, so since it was created in Washington, it can be fixed in Washington. Perfectly capable of doing it. In fact to me, it's a symptom of how dysfunctional our economic policy has become at this point in time. It's a lot of uncertainty, unpredictability, temporary stimulus packages, temporary reduction in taxes, temporary postponements and what's happened, the fiscal cliff just happened to synchronize that so it all occurs at the same time, so it's really a symptom of the problems.

I think the best guess is that there'll be a kick-the-can-down-the-road type of solution at this point. I hope it's better than that. I hope it's an agreement to do something substantial, but I don't see that right now. People seem to be convinced there's only one way to get this thing fixed, but I think it's a real concern. Even if it's a temporary solution, it's a concern because we'll continue, I think, with these very uncertain, unpredictable policies.

Morgan Housel: Of course, the reason we're here is because the can has been kicked down the road so many times already in the past two years, with the debt ceiling deal last summer, which is more or less why we're here right now. Is there any reason to believe that if we kick the can down the road again we're eventually going to be able to fix this topic? And I guess what I think about a lot is as long as borrowing costs are so low, there was no real urge for Congress to address the deficit. Is that fair?

John Taylor: Well, it's a factor, that's for sure, but remember just two years ago there was this tremendous outcry around the country to do something about the debt. That's really where the 2010 elections came from and so there was definitely a tremendous amount of concern. I think it's still there. It makes it easier, obviously, especially with the Fed buying a lot of the debt, a lot of long-term debt, that makes it easier. But I think it will get solved because people recognize this as such a problem.

Morgan Housel: And of course you have one side that says, "Don't touch taxes." You have one side that says, "Don't touch entitlements." To create a real, substantial deficit reduction bill that would make a difference over the long haul, do both of those sides need to loosen up their stances?

John Taylor: You know it's only in a political way it seems to me. From an economic perspective, at least my economic perspective, I see a way out of this where you simply bring spending as a shared GDP back to where it was before the crisis in 2007. That's about 20%. Obviously, we can do that. We did it just a short number of years ago. If you do that, you don't have to have revenue increases. You basically will get revenues rising with stronger economic growth and to do that you need to have a sensible reform of Medicare and Medicaid, I think things that would make people's lives better.

So as I see it from an economic perspective, there's a much more sensible way out of this than to try to have to raise taxes in very weak economic times. I think the sense of a bargain you're referring to is for political reasons and obviously we have to face up to that. But I think the more people understand the economics of it, the more chance we have of getting to a more sensible solution.

Morgan Housel: So purely from an economic standpoint, if we were to go over the fiscal cliff on January 1, what would happen then?

John Taylor: Well, we'd have a massive tax increase going back to the (unclear). It would be a serious hit to the economy. It would be a slowdown, negative growth. I think there's not much question about that. I would distinguish, though, between a massive one-time tax increase and a more gradual decline in spending. Right now, with the Budget Control Act of 2011, there's an actual quite gradual decline in spending. It's done in a rather (unclear) way because it's done with a sequester. But the path of spending is quite; in fact, it's exactly the same path that's in the Simpson-Bowles proposals. I think that would be good for the economy if we had a path like that, to fix the sequester, have it more sensible. So on the spending side, I think it's quite possible to come out of this without a recession, without even a slowdown quite frankly. It's the tax side that such a concern because it's massive and it occurs at one point in time.

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