U.S. CBO sees worse economic wreckage from "fiscal cliff"

WASHINGTON Wed Aug 22, 2012 4:09pm EDT

A picture illustration shows a 100 Dollar banknote laying on one Dollar banknotes, taken in Warsaw, January 13, 2011. REUTERS/Kacper Pempel

A picture illustration shows a 100 Dollar banknote laying on one Dollar banknotes, taken in Warsaw, January 13, 2011.

Credit: Reuters/Kacper Pempel

WASHINGTON (Reuters) - Massive U.S. government spending cuts and tax hikes due next year will cause even worse economic damage than previously thought if Washington fails to come up with a solution, the Congressional Budget Office warned on Wednesday.

Without action by Congress to avoid a "fiscal cliff," Americans should expect a "significant recession" and the loss of some 2 million jobs, CBO director Doug Elmendorf said in his gloomiest assessment yet.

He said the economy is already being "held back" by the mere anticipation of the fiscal cliff and the uncertainty surrounding it, causing businesses to put off investment and hiring decisions.

"The sooner that uncertainty is eliminated, the better," Elmendorf told a news conference. "The stakes are very high in the fiscal policy decisions we're going to have to make very shortly."

The report from the non-partisan agency should intensify pressure on Congress and the White House to resolve deep differences over cutting spending or extending tax cuts enacted during the George W. Bush administration.

But chances for a deal before the November 6 election are slim. They could improve during the post-election lame-duck session of Congress, but that's unpredictable as well.

Reactions to Tuesday's dire warning did not signal any signs of movement by Democrats nor Republicans from entrenched partisan positions that form the basis of their campaigns.

"Today's CBO report is another indictment of President Obama's economic policies that have resulted in overspending, increasing debt and a growing financial burden on the next generation," said Amanda Henneberg, a spokeswoman for Mitt Romney's Republican presidential campaign.

White House Press Secretary Jay Carney batted the blame back to Republicans in Congress.

"They're willing to hold the middle class hostage unless we also give massive new tax cuts to millionaires and billionaires -- tax cuts we can't afford that would do nothing to strengthen thee economy," Carney said in a statement.

WORST FISCAL TIGHTENING SINCE VIETNAM

The "fiscal cliff" refers to the impact of around $500 billion in expiring tax cuts and automatic spending reductions set for 2013 as a result of successive failures by Congress to agree on some orderly alternative method of reducing budget deficits.

Failure to avoid it would spark U.S. fiscal tightening on a scale not seen since 1969 tax increases to pay for the Vietnam War -- slamming the economy into recession as it did back then.

The CBO estimated that U.S. gross domestic product under this scenario product would shrink 0.5 percent in 2013, with a crushing first-half contraction of 2.9 percent followed by a weak second-half rebound of 1.9 percent growth.

In a May estimate of fiscal cliff effects, the CBO had forecast full-year 2013 GDP growth of 0.5 percent, with a 1.3 percent first-half contraction and second-half growth of 2.3 percent.

The main reasons for the gloomier outlook now are a weaker global economy, the growing uncertainty mentioned by Elmendorf about what Congress will do, and a determination that the cliff is somewhat steeper than previously thought.

The May estimate did not include the effect of expiring payroll tax cuts and the end of extended unemployment benefits. Factoring in the end of those streams of cash to Americans would increase the shock to aggregate demand.

WEAK GROWTH UNDER EXTENSION

Were Congress to extend all current tax policies and simply halt the automatic cuts, as many Republicans have proposed, the CBO said the economy would continue to grow, albeit weakly.

GDP growth under this more optimistic scenario would be modest in 2013 at 1.7 percent, with an 8.0 percent unemployment rate compared with 9.1 percent should the U.S. go over the fiscal cliff.

But it would cause the deficit to remain above $1 trillion for a fifth consecutive year, versus a sharp fall to $641 billion under the fiscal cliff scenario. Elmendorf said keeping deficits this high would greatly increase the chances of a U.S. debt crisis that spikes interest rates higher, dramatically raising all borrowing costs.

The current fiscal year, which ends on September 30, is on track to produce a $1.128 trillion deficit, CBO said -- a slight reduction from its most recent estimate of $1.171 trillion [ID:nL2E8JM5ED]

Part of this reduction was due to lower spending on the federal health programs Medicare and Medicaid.

Helen Fessenden, an analyst with Eurasia Group, which tracks political risks for investors, noted that the CBO report showed some slightly better-than-expected revenue estimates, which could buy the U.S. Treasury a bit more time before the $16.4 trillion U.S. debt ceiling needs to be raised.

Currently, the Treasury expects to reach that limit around the end of the year, but can take extraordinary measures to stretch its borrowing capacity into early 2013.

The next major development on the fiscal cliff is a report due from the White House on September 6 that details programs where the Obama administration plans to concentrate the automatic spending cuts should they occur. Half $109 billion in cuts for 2013 will be borne by the military and half by domestic programs.

(Additional reporting by Kim Dixon; Editing by Fred Barbash, Chizu Nomiyama, John Wallace and Phil Berlowitz)

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