Even a short fall from ‘fiscal cliff’ would be quite painful
By Neil Irwin,
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. Last week, the Congressional Budget Office said it figures that the tax increases and spending cuts scheduled to take effect Jan. 1 absent an agreement between Congress and President Obama would subtract 2.9 percentage points from the gross domestic product by the end of 2013 and would cost 3.4 million jobs.
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 would happen if we went off the cliff just a little bit? If we had one or two or four weeks of automated austerity, would it really matter?
Some would argue that it wouldn’t be very bad. 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 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 JPMorgan 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 it 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 would add up to about $56 billion a month, which is a lot of money — about 4 percent of gross domestic product — but should, in theory, at least, do only modest damage to the economy if it lasted just 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 past 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 partly refunded if Congress made an eventual deal retroactive, and there is a good chance it would.
But all this seems like a naive 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 haven’t followed the buildup to the fiscal cliff 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.
“As we consider 2013 today, let us assume that a solution to the fiscal cliff will be found,” Arne Sorenson, chief executive of Marriott International, said 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 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. 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 the unemployment rate 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,” Feroli said, “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 what happened on Sept. 29, 2008, when the House rejected the bank bailout bill known as the Troubled Assets Relief Program that the George W. 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 stock index dropped almost 9 percent in one of its worst days ever.
That got 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.