Columbia Management Perspectives: Fiscal Cliff — The CBO Report
By Marie Schofield
The Congressional Budget Office (CBO) released a report covering their expectations of the economic effects of the coming fiscal cliff the economy faces next year. The government currently runs an annual budget deficit in the neighborhood of $1.2 trillion or about 7% of gross domestic product (GDP). The CBO estimates that expiring fiscal policies which will raise taxes and lower government spending will reduce the deficit in 2012 and 2013 by $607 billion (or about 4% of GDP), but will also exact a cost in terms of direct and indirect effects on economic output (lower consumer and business spending, higher unemployment, guarded business sentiment). Adjusting for those effects, the deficit would drop by (a smaller) $560 billion in those years but still prove a significant drag on growth.
Over the long run smaller deficits are necessary, as we can’t continue to spend more than we take in. But a fiscal contraction of this size over the short run would be unprecedented. As a result, the CBO believes economic growth will be just 0.5% for 2013 overall, and they foresee a small contraction (a recession) in the first half of -1.3% followed by more normal growth in the second half of 2.3%. The largest headline in the report for me was not the admission that recession risk next year is real and probable without some action — I endorse that view. It was that they continue to believe without this fiscal restraint, GDP could grow 4.4% in 2013 due to higher spending by consumers and a rise in employment of two million.
For the very first time in the post-war period, we are almost three years into a recovery with not one quarter of growth over 4%. Their econometric models need a reality check. But avoiding any fiscal adjustment is also not tenable. They acknowledge deficits this large cannot be financed over the long term, as the debt burden would become increasingly hard to manage and therefore unsustainable. But they believe the immediate fiscal adjustment would have severe economic consequences with an almost 4% differential effect on growth. An alternative fiscal scenario (kicking the can, so to speak) where some tax cuts and policies are extended on a short-term basis would avoid a recession early next year.
Under this scenario, they forecast growth of 2.1% in 2013 with an associated increase in employment of 1.3 million. This is a more reasonable assessment but still probably optimistic. But the point is this rosier scenario subtracts over 2% from forecasted growth.
The CBO is obviously trying to focus attention on this thorny issue, by publishing official estimates of the economic consequences of the coming fiscal adjustments in hope of pushing lawmakers to tackle this before we get to the December cliff date. The report has generated a fair amount of attention and discussion, and, modeling aside, the recession risks the CBO has flagged are real. It is hard to handicap this because it is such a wildcard — but so key to the outlook. Political paralysis together with the tight window after the election also limits how much can be done. I believe trend growth is closer to 1% - 2%. Figuring in a best case fiscal drag of 2% leaves us with a mild recession forecast next year. Worse if lawmakers are idle and allow a larger adjustment.
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