Analysis: Fiscal cliff could hit economy harder than many expect

WASHINGTON Sun Oct 28, 2012 1:57pm EDT

A U.S. flag decorates a for-sale sign at a home in the Capitol Hill neighborhood of Washington, August 21, 2012. REUTERS/Jonathan Ernst

A U.S. flag decorates a for-sale sign at a home in the Capitol Hill neighborhood of Washington, August 21, 2012.

Credit: Reuters/Jonathan Ernst

WASHINGTON (Reuters) - The United States runs the risk of a recession far deeper than many investors and policymakers may think if lawmakers fail to avert looming tax hikes and cuts to public spending.

Absent action by Congress, the country will face the so-called fiscal cliff at the start of next year, a combination of lower spending and higher taxes that is expected to extract about $600 billion from the economy.

Many economists think every dollar of deficit reduction will subtract nearly the same amount from economic growth.

By that measure, the current course could cause the economy to contract by 0.5 percent in 2013, according to estimates by the Congressional Budget Office (CBO) that have been largely embraced by Wall Street and the U.S. Federal Reserve.

But research by economists in academia and at the International Monetary Fund suggests a dollar of deficit reduction could drain as much as $1.70 from the economy, making the prospective belt tightening much more dangerous.

"You can take that 0.5 percent contraction and double it," said Barry Eichengreen, an economist at the University of California, Berkeley.

These researchers suspect fiscal contractions take a bigger-than-normal bite from economies when interest rates are very low, as is the case at the moment in the United States and in much of the developed world.

One explanation, Eichengreen said, is that when rates are higher, central banks can easily lower them to provide a counterweight to austerity. But when rates are near zero, as they are in the United States, it's harder to ease the pinch.

Historical data suggests higher taxes or lower government spending normally lead households to cut back on purchases only modestly. In the three decades through 2009, a dollar in government austerity would suck only half that from the economy, according to IMF research published this month which examined fiscal policy in 28 countries.

But economies around the world appear to be acting differently since the Great Recession. The IMF said it appeared that every dollar of recent fiscal consolidation has drained anywhere from $0.90 to $1.70 from economies.

The IMF said this suggested central banks have been having difficulty offsetting the impact from tighter budgets.

That could well be the case in the United States as well. The Fed pushed overnight rates to near zero in December 2008 and has resorted to the unconventional policy of purchasing government and housing-related bonds to revive the economy.

The central bank's chairman, Ben Bernanke, has acknowledged he would not be able to fully offset the pain if the economy runs into the "fiscal cliff."

With the U.S. jobless rate at 7.8 percent and the recovery still shaky, the possibility of a greater-than-expected hit to activity might be food for thought for lawmakers, who will be looking to cut some sort of deal on the budget before year end.


There's little room for error. Forecasters expect economic growth next year of just 2.1 percent, with the jobless rate edging down only slightly.

As it is, economists believe even the level of danger outlined by the nonpartisan CBO will be enough to propel lawmakers, who are deeply divided over taxes and spending, to reach an accord, although signs have yet to emerge that a deal is starting to gel.

"No political party wants to go down in history as the one that triggered the second half of the worst recession since the Great Depression," said Paul Dales, an economist with Capital Economics in London.

Capital Economics expects Congress will allow just under $100 billion in fiscal tightening, which it thinks would knock the same amount off gross domestic product (GDP).

Yields on U.S. government debt suggest investors as a whole are betting on even less tightening next year, according to research by analysts at Bank of America.

Bank of America itself expects lawmakers will allow much of the fiscal cliff to transpire, leading to about $325 billion in budget tightening, enough in their view to stall job growth.

Like Capital Economics and many other research units in the financial world, Bank of America presumes every dollar of tightening would drain the economy by about the same amount, although it says a bigger effect is possible.

"The economic impacts could be worse than our baseline assumptions," said Michael Hanson, an economist with the bank in New York.

Eichengreen and others who have studied economic data from the Great Depression, another time central banks were constrained, found the drag from a tightening of fiscal policy was much higher at the time. Eichengreen thinks currently the so-called multiplier is about 1.7, in line with the upper range of the IMF's estimate.

If he is right, even avoiding just half of the fiscal cliff would not be enough to steer the economy clear of recession.

Earlier this month, Senate Republican leader Mitch McConnell argued for not "a penny less" than $109 billion in budget tightening next year. But even a tightening in the budget of that magnitude would have an outsized effect if Eichengreen and others are on the mark.

"It would make more sense to assure a strong self-sustaining recovery before embarking on significant fiscal consolidation," Goldman Sachs economists said in a recent report that summarized research pointing to heightened risks of budget slashing.

(Reporting by Jason Lange; Editing by Tim Ahmann and Sandra Maler)

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Comments (13)
usagadfly wrote:
Until the USA holds open, free and fair elections without the option of “buying” all candidates in advance, we will continue to suffer under a system that has functionally been able to disconnect itself from elections. American “elections” in fact offer no significant choice of policy paths which nullifies the process as an “election” just as it does in “developing” country dictatorships.

The American Government is directed by campaign “contributions” rather than by the majority of human voters. It is purchased, not elected.

Oct 28, 2012 2:01pm EDT  --  Report as abuse
Regulator623 wrote:
BENGHAZI UPDATE: WHERE IS THE RAGE??? I’m posting here because the media is protecting Obama… By now everyone knows that Obama lied about Benghazi and was still lying about it at the UN on 9/25, two weeks later and this week. No protest, No video. Denied security requests. And, 4 Americans got murdered.

The US military NEVER NEVER NEVER leaves a man behind to die… At least not until Obama’s Presidency…

Have you heard Charles Woods, attorney, judge and father of murdered Navy Seal Ty Woods? He called Beck on Thursday and was interviewed by Hannity yesterday to try and get the truth out:

When his son’s body arrived at Andrews AFB, Mr. Woods met with President Obama, VP Biden and Hillary Clinton.

According to Mr. Woods: President Obama wouldn’t look him in the eye, mumbled an insincere apology and was like shaking hands with “a dead fish”.

VP Biden inappropriate exclaimed in front of the parents: Your son must have balls the size of cue balls. And, Hillary continued the lie…

Ms. Clinton told him: We’ll get the guy who made this video…

Why didn’t Obama, Biden and Hillary tell him: We’ll get the terrorists who MURDERED your son?

All Mr. Woods wants to know is: Who, at the WH, gave the order NOT to save my son?

The attack and firefight last for 7+ hours… Cameras in the compound, drones overhead and satellites streamed LIVE LIVE LIVE video to the State Department, CIA, FBI, Pentagon and the WH Situation Room. Did Obama watch Ambassador Stevens and three other Americans die in REAL TIME, or did he sleep on it and watch it in the morning en route to more campaigning in Las Vegas?

Mr. Woods wants to know: Did Obama personally block the orders to send in the Quick Reaction Force commandos from Sicily or elsewhere nearby? The Seals were using lasers to “paint” the targets where the mortar attacks were coming from, for air support that never came…

How’s that for leaving them for dead? I’m sure the FBI, CIA and military are brimming with confidence to see how the Commander-in-Chief “has their back”. Making a mockery of these murders, lying about it and now blaming the “fog of war”.

Why did it take three weeks to get an FBI investigation team there, when CNN could stroll in the next day and get Ambassador Steven’s journal? I’m sure Team Obama (and the biased, corrupt media) are just hoping voters won’t find out the truth until after the election. After all this is all about Obama and HIS campaign. Remember, to Obama these murdered Americans are just “bumps in the road.” NO RAGE from Obama…

Americans were MURDERED and Obama, Hillary and everyone else let it happen, then LIED and continue the COVER-UP.

Where is the RAGE at EVERY campaign event Obama has? How about the media? If this had been Bush or any Republican they’d be covering this non-stop, 24/7. Are they so far gone for Obama they have no morals, or sense of right and wrong, either?

It is time for us to STAND UP FOR our military! Where is the RAGE????????????

(If you agree, please help get the word out: copy, paste, re-post, improve this on the ABC, CBS, NBC, CNN web sites. Tweet Wolf Blizer, Major Garrett, Diane Sawyer, Brian Williams, etc.)

Oct 28, 2012 3:04pm EDT  --  Report as abuse
Turf12 wrote:
since the first 2 posts have nothing to do with the subject matter….

won’t the fiscal cliff cut the deficit? i thought that was the most important thing? it appears the most important thing is whatever the gop doesn’t get.

Oct 28, 2012 4:21pm EDT  --  Report as abuse
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