The economy (probably) can’t survive a short dive into austerity crisis

November 13, 2012

Welcome to the first installment of Econ Agenda, a new column from Wonkblog economics editor Neil Irwin. Each weekday morning, the column will offer authoritative, agenda-shaping analysis of the most urgent economic news of the day.

The question of “What will happen if the United States goes off the fiscal cliff,” allowing a self-induced austerity crisis, has a pretty simple answer.

There will be a recession, and probably a pretty deep one. The Congressional Budget Office said last week it figures that the suite of tax increases and spending cuts scheduled to take effect Jan. 1 absent an agreement between Congress and President Obama, would subtract 2.9 percentage point from the gross domestic product by the end of 2013, and cost 3.4 million jobs.

House Speaker John Boehner (Ohio) will lead negotiations for House Republicans.  (Susan Walsh -- Associated Press)

But that isn’t really the most urgent economic question to ask; no one in government is advocating for all that austerity to take effect permanently. The fundamental question for next year is: “What will happen if we go off the cliff just a little bit.” If we have one, or two, or four weeks of automated austerity, would it really matter?

Some would argue that it won’t be very bad at all. That’s the answer the normal analytical tools would offer. But this is one of those situations where the normal analytical tools might be leading people astray: There is every reason to think even a short exercise in cliff-diving would hurt quite a lot.

“I fear it could be much, much worse than those who blithely assert that it wouldn’t be so bad,” said Michael Feroli, chief U.S. economist at J.P. Morgan Chase. 

This also is one of the most important questions hanging over the negotiations, because it is a much more likely scenario than going off the cliff entirely and permanently. It’s also a situation we can’t know for sure, simply because the situation is unprecedented.

In a narrow sense, a short voyage off the cliff shouldn’t crush the economy too badly. The CBO estimates that the full brunt of the policies add up to about $56 billion a month, which is a lot of money — about 4 percent of GDP — but should, in theory at least, do only modest damage to the economy if it lasted only a few weeks. One month of austerity along those lines would subtract only about a third of a percentage point from growth for the full year, before accounting for multiplier effects.

For comparison, the U.S. economy grew at a 1.8 percent rate over the last year; if a single month of fiscal cliff-style austerity had been in place, that number would have been more like 1.4 percent. For a middle income family, based on numbers from the Tax Policy Center, a single month over the cliff would cost $167 — and even that may be completely or partially refunded if Congress makes an eventual deal retroactive, which there is a good chance it would.

Families may not even see a hit to their paychecks at all. If the Treasury Secretary determines that a deal is imminent, companies would not need to adjust their withholding tables, so after-tax incomes would not necessarily decline.

But all this seems like a naïve way of viewing the situation, one divorced from the real ways that markets and psychology interact with economic forces.

There are plenty of actors in the economy who either haven’t followed the buildup to the fiscal cliff at all or have done so with only a wary eye and crossed fingers. In a slew of corporate earnings conference calls in recent weeks, executives of major companies have mentioned the fiscal cliff as one of the many looming threats, but rarely offered comments more detailed than “we hope and expect that the politicians will solve it.”

“As we consider 2013 today, let us assume that a solution to the fiscal cliff will be found,” said Arne Sorenson, chief executive of Marriott International, in its earnings call last month.

It is easy to imagine that if there is no solution, the Sorensons of the world will reconsider their own capital spending and hiring plans; even a few weeks in which Washington allows dramatically tighter fiscal policy could lead to a haze of uncertainty and delay as that basic assumption -- that at the end of the day, after all the sturm und drang, the politicians will deliver a compromise -- proves untrue.

Financial markets, if the past is a guide, will only reinforce these trends. When Standard & Poor’s downgraded the U.S. government’s credit rating in August 2011, citing a dysfunctional process for resolving the debt ceiling standoff (a deal that set the stage for the current negotiations), there was no apparent damage to the government’s finances — borrowing costs actually fell — but plenty of extra volatility in world financial markets.

Markets don’t like risk. And for the world’s largest economy to adopt a yo-yo approach to fiscal policy -- steep tax increases and spending cuts one month, a reversal the next -- would be an extra layer of risk for already jittery markets. A falling stock market hammers both households’ wealth and confidence and businesses’ willingness to invest.

Who knows if a few weeks of austerity would cause a recession or merely a soft patch in growth. But with unemployment at 7.9 percent, neither is particularly welcome. “I don’t know whether reversing this in a few weeks would turn the business cycle around like turning on a switch," said Feroli, "but it seems like losing this gamble would be very costly for everybody.”

Ironically, while financial markets are a transmission mechanism that could instantly spread the damage of a dive into austerity, they also may be a tool to force it.

The economic impacts of any legislative debate are almost impossible to measure in real time. But the stock market renders its verdict every second of the trading day. If the talks are going off the rails in the final days of December, with no accord in sight, it may well be the markets, looking forward to the ill-effects to come, that provide a certain focus for recalcitrant lawmakers.

That is exactly what happened on Sept. 29, 2008, when the House of Representatives rejected the bank bailout bill known as the Troubled Asset Relief Program that the Bush administration was pushing. As the votes came across the screen on C-Span, the stock market began a stunning descent, and the Standard & Poor’s 500 dropped almost 9 percent in one of its worst days ever. It would have taken weeks or even months to know how bad the damage to the real economy would be from a failure to rescue American banks.

That got the lawmakers' attention, and four days later they passed the bill with only modest changes. We can hope that markets have a similar ability to force the issue and avert even a short-term bout of austerity this time around.

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