What if we went over the ‘fiscal cliff’…forever?

November 30, 2012

Everyone agrees that allowing all of the scheduled spending cuts and tax hikes to take effect in January would be devastating to the economy next year. But let's take the long view: What would they do to the economy over 10 years? Macroeconomic Advisers took a look and finds that the long-term picture isn't pretty either: According to their new analysis, there would be a budget surplus as soon as 2018, with a 60 percent debt-to-GDP ratio by 2021, but economic growth would take a pummeling. 


Colombian cliff diver Orlando Duque launches off a 78-foot rock peninsula in La Rochelle, France. (Dean Treml -- AFP-Getty Images)

The firm compared the full-blown "Do Nothing" approach to a baseline compromise scenario that would reduce the long-term deficit by $3.5 trillion over 10 years through both spending cuts and increases on the top two marginal tax rates that begin in 2014.

Like other analysts, Macroeconomic Advisers predicts that the "Doing Nothing" approach would cripple the short-term economy: Unemployment would rise to 8.5 percent by the end of 2013; the stock market would fall about 15 percent in the beginning of the year and barely recover; and GDP growth would be anemic. 

After 2013, economic growth starts to pick up again, but the severe fiscal contraction from the "fiscal cliff" would lower GDP growth and raise unemployment for the next decade, both because of the higher marginal tax rates and the spending cuts:

The unemployment rate averages 0.5 percentage point higher for the decade, and the cumulative loss in output over that span is 10% of this year’s GDP. Treasury yields are lower and that, by itself, would argue for a higher capital stock. However, given the combination of higher marginal tax rates on capital, the initial widening of both private credit spreads and the equity risk premium, and the cyclical suppression of investment, capital stocks are actually lower in 2021 than under the grand bargain. Only in a second decade could the benefit of a lower debt-to-GDP ratio begin to manifest itself as a higher standard of living.

No one is proposing that we go over the fiscal cliff for the next decade: Even the cliff-divers want to go over just to increase the Democrats' leverage and come to a deal quickly thereafter. But the analysis makes it clear what the real problem with the cliff is: The underlying policies are anti-growth, and any short- or long-term replacement that aims to fulfill the cliff's main purpose of deficit reduction has to balance that with an effective pro-growth policy. 

It's also a reminder that for all the politicians who yearn for a budget surplus, there's nothing about a budget surplus that assures a healthy economy. Indeed, a going off the cliff permanently would get us a surplus, but a grand bargain that reduces debt-to-GDP but still leaves us with deficits would get us more growth.

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Neil Irwin · November 30, 2012