If There Were Any Doubt That Fiscal Cliff Failure Would Lead To Recession...


Photo: Flickr/pfala

On 1 January 2013, the United States could be looking down the fiscal cliff of about US$600 billion of tax increases and spending cuts.  That is, if the Congress fails to reach any compromise.

The fiscal tightening will happen should the congress not extend the Bush tax cuts and the payroll tax cuts (i.e. let them expire).  On top of that, as part of the deal for last year’s increase of the debt ceiling, a super committee was formed and was asked to come up with some US$1.2 trillion over the next 10 years.

And as the super committee failed to do so, an automatic spending cuts will kick in on 1 January 2013 as part of the deal to raise the debt ceiling (known as sequester).  Not to mention that the debt ceiling will likely be met again early next year.  With the coming election and all the usual gridlock in the congress, political uncertainty is arguably quite high.

The table below by Goldman Sachs illustrates the timeline of the important dates of key political events which could have potential impact of fiscal policy.


Photo: Goldman Sachs

We know that the US government has been tightening fiscal policy (sort of) in a sense that deficit reduction in the past year has been the highest in dollar term.  As a result, for many quarters now, the government is making negative contribution to GDP growth.



Photo: FRED

Should the Congress fail to come up with any compromise and let all these tax cuts expire and spending cuts kick in (which is, certainly, not the most likely scenario at the moment), Goldman Sachs expects that the negative impact would be roughly 4% of GDP.

Given the current trend of some 2.0% growth or so, that magnitude of fiscal drag will easily put the US economy into recession.  The chart below from Alec Phillips of Goldman Sachs shows the effect of fiscal policy on GDP growth.  As you can see, should everything expire on 1 January 2013, the drag on GDP will be close to 4%, enough to put the economy into recession.



Photo: Goldman Sachs

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