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The Gathering Fiscal Storm

We have written about the fiscal cliff and its possible economic consequences several times in recent months. Other organizations have been more sanguine about the impact of the expiring tax cuts and large federal spending reductions that are set to occur at the beginning of January 2013. Today, the Congressional Budget Office (CBO) released its latest assessment of the fiscal cliff and the analysis bolsters our argument: Going over the cliff inevitably leads to a serious recession.

Indeed, in its report, CBO is dramatically more pessimistic about the impact of the fiscal cliff on the nation’s economy than it was earlier this year in its original Budget and Economic Outlook. It had projected that under current law – i.e., the fiscal cliff happens – real economic growth in 2013 would be 1.1 percent. CBO now estimates, however, that if Congress and the president allow the fiscal cliff to occur, unemployment will rise to 9.1 percent next year and the economy will contract by 0.5 per cent. Further, the biggest damage will occur in the first half of 2013, during which CBO expects real gross domestic product (GDP) to fall at an annual rate of nearly 3 percent. This implies that the economy will be significantly weak in the first half of 2013, reflected both in real growth and unemployment rates.

There are at least two implications of cruising over the fiscal cliff that too few politicians seem to have thought through. First, the cliff has a disproportionately adverse impact on middle- and lower-income workers. For example, expanded reach of the Alternative Minimum Tax, loss of Temporary Assistance to Needy Families (TANF) benefits, and expiration of the payroll tax holiday and extended unemployment benefits all combine to increase the burden on middle- and lower-income families.  Add to that significant increases in taxes and cuts to the Earned Income and Child Care tax credits, and one can easily envision a worse economic reaction to “going over the cliff” than even CBO foresees.  The odds of a consumer-driven recovery in 2013 would seem unlikely.  

Second, the fiscal cliff is inherently linked to the fragile world economy.  CBO expressly mentions that the combination of national and international economic fragility makes the potential impact of the fiscal cliff more damaging. 

Many economists have worked to compare the growth coming out of typical recessions to recoveries from financial recessions.  Such recoveries, history shows, take longer and are more fragile than “normal” recoveries.  We are witnessing these direct and associated effects not only in the U.S., but around the world: weaknesses in Europe remain unresolved; Brazil and India face different, but difficult, economic challenges; China has been preparing for a deliberate slowdown in its economy for quite a while; and Russia depends on commodities such as crude oil, which have naturally fallen precipitously in the serious recession.  

In this context, we continue to believe that failure to act to avoid the fiscal cliff, and failure to forge a medium- and long-term comprehensive fiscal package, represent a kind of recklessness that could lead to worse outcomes than we imagine.  CBO confirms the risks of political inaction, both in the short- and long-term.

The consensus among analysts seems to be that both Democrats and Republicans believe that they have a tactical political advantage if the fiscal cliff materializes.   This course, which we call “let ‘er rip,” will lead to inaction before the elections, and could lead to inaction in the lame duck.  If that occurs, any short-term tactical political gain will be lost in what we believe will be an economic mistake of the highest order.

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2012-08-22 00:00:00
A CBO report confirms both the short- and long-term risks of political inaction on the fiscal cliff

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