Is the CBO too optimistic about the damage from the fiscal cliff?

October 22, 2012

Let's assume that the United States jumps right off the fiscal cliff next year. That means all of the Bush tax cuts expire. Those big defense and domestic spending cuts from the sequester kick in. The deficit shrivels by more than $500 billion in 2013. How much damage would that inflict on the U.S. economy?

Whoa, steep cliff you got there. (Brynn Anderson/Associated Press)

Back in August, the Congressional Budget Office predicted that the nation would endure some short-lived, relatively mild pain. The U.S. economy would go into a shallow recession in the first half of 2013 — shrinking about 0.5 percent over the year — before roaring back. According to CBO, the economy would then grow at a healthy clip of 4.3 percent per year between 2014 and 2017. And, as a bonus, America's short-term deficit problem would mostly vanish.

That doesn't sound too apocalyptic. But is this forecast correct? After all, over in Europe, heavy austerity appears to have crippled growth in countries like Spain and Greece. What’s more, the International Monetary Fund recently released a report conceding that tax hikes and spending cuts can inflict far more damage on weak economies than previously thought.  Is it possible that CBO might be understating the damage from the fiscal cliff?

At least one group thinks so. A report (pdf) earlier this year from the Levy Economics Institute called into question the CBO's forecasts that the U.S. economy can get back to full potential by 2018 even if we go over the fiscal cliff. The authors, Dimitri Papadimitriou, Greg Hannsgen and Gennaro Zezza argue that it's hard to make the numbers work unless you assume that U.S. households are about to go on an unprecedented borrowing binge.

The key graph from the report is below. Households, the Levy folks note, would have to carry more debt than they did at the height of the housing bubble in order for these rapid growth casts to pan out. (That's because budget-cutting would act as a drag on the economy and exports aren't likely to expand enough to make up the difference.)

As Walter Kurtz of Sober Look (who pointed out the Levy report) notes, this is an awfully unlikely scenario. All indications are that U.S. households are rushing to pay down their debts right now. There's little indication that Americans are preparing to go on another massive borrowing binge. That suggests the CBO might be too sanguine about economic growth in a post-fiscal-cliff world.

So what's the alternative? The authors of the report model three scenarios for the future course of the economy:

In Scenario 1, there's a surge in household borrowing and spending. This is fairly unlikely. In Scenario 2, the Bush tax cuts are extended and households increase their borrowing and consumption at a slower, more realistic rate. Unemployment stays high for years to come. In Scenario 3, Congress extends the tax cuts and adds an extra bit of fiscal stimulus. Unemployment goes down a bit further, but still stays high for years to come.

According to the Levy Institute’s modeling, unemployment will likely stay elevated for a long time under any realistic scenario, fiscal cliff or no. (Though it's worth noting that this report came out before the Federal Reserve's latest quantitative easing program, so it's unclear how that would factor in.) "Based on our results," the authors write, "we surmise that it would take a much more substantial increase in fiscal stimulus to reduce unemployment to a level that most policymakers would regard as acceptable."

Related: Suzy Khimm explains why even deficit hawks don't want to go over the fiscal cliff.

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