GOLDMAN SACHS: Here Are 4 Ways The 'Fiscal Cliff' Could Play out

wheel of fortune

Investors and analysts everywhere are warning of the fiscal cliff that is approaching at the end of 2012.

Unless Congress acts, more than $600 billion in tax and spending provisions will change at the end of the year. And this will impose fiscal restraint at a time when the U.S. economy is growing very gradually.

In a new note, Goldman Sachs’ Jan Hatzius and Alec Phillips say their economic forecast assumes an extension of the 2001/2003 tac cuts and the replacement of the spending cuts with other savings.

Here are the four most likely outcomes that they expect.

A YEAR-END BARGAIN: 5% Probability

The likelihood of a 'grand bargain' between the Democrats and Republicans is very low since there will be little time to work out such a deal after the election.

'A shift in control of Congress or the White House would likely rule out any reform agreement until the election winners take power. Eventually, a compromise reform package between the parties is likely but this seems very difficult to achieve in the short time between the election and year end.'

Source: Goldman Sachs

A ONE-YEAR OR LONGER EXTENSION OF MOST OF THE LARGE PROVISIONS: 20% Probability

Congress could possibly extend some or most of the policies for multiple years in December. But it is more likely that after trying for a long-term extension, Congress will settle on a one-year extension, with the expectation that end-2013 would be the deadline for broader fiscal reforms.

'A long-term extension seems more likely if the election produces a status-quo election result than if control of the White House or one or both chambers of Congress changes hands.'

Source: Goldman Sachs

EVERYTHING EXPIRES: 35% Probability

While there is a possibility that all the provisions could expire, this is isn't Goldman's base case. But there are two reasons this could happen:

  1. Democrats and Republicans fail to compromise on the upper income tax cuts and other issues and realise letting the policies expire to force an agreement would be more to their advantage.
  2. A change of power in Congress of the White House is likely to cause provisions to expire. In this case, the decision would be postponed till January when the next Presidential term and Congress begin. 'At that point, a retroactive reinstatement of expired policies could be put in place.'

Source: Goldman Sachs

A SHORT TERM EXTENSION, WITH AN EXPECTATION OF A LONGER-TERM RESOLUTION: 40% Probability

A compromise on these policies before the end of 2012 is likely to be very difficult and officials could instead choose a short-term extension of about three to six months. This extension could be made with the understanding that the next such extension would have to involve more fundamental fiscal reforms.

'In essence, this would extend most of the 'fiscal cliff' policies into mid-2013, with the expectation that by that point a broader reform package could be developed and agreed to.'

Source: Goldman Sachs

Now here's a look at the current state of the U.S. economy...

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