Staring At The “Fiscal Cliff”

Does the government that governs least also govern best? The famous quote will be put to the test if Congress and the White house don’t resolve the “Taxmageddon” train wreck coming our way. What’s at stake? Perhaps economic growth, according to a new report from the Congressional Budget Office: “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013.”

Unless the government acts between now and the end of the year, a combination of expiring tax cuts and broad reductions in spending will kick in automatically. It doesn’t take a genius to recognize that this wave of fiscal change, if implemented overnight in one fell swoop, could be toxic for a fragile economic recovery. The CBO report says as much:
If current law is allowed to unfold unchanged, the CBO expects that the economy will retreat at an annual real (inflation-adjusted) rate of 1.3% in the first half of 2013—a decline that “would probably be judged to be a recession” by the National Bureau of Economic Research. In that case, overall growth for 2012 is expected to be a shallow 0.5%.The CBO engages in a bit of scenario analysis:

What would happen if lawmakers changed fiscal policy in late 2012 to remove or offset all of the policies that are scheduled to reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013? In that case, CBO estimates, the growth of real GDP in calendar year 2013 would lie in a broad range around 4.4 percent, well above the 0.5 percent projected for 2013 under current law.

Ultimately, there’s the fine line between balancing short-term economic challenges and promoting long-term fiscal rectitude. As the CBO advises:

However, eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would reduce output and income in the longer run relative to what would occur if the scheduled fiscal restraint remained in place. If all current policies were extended for a prolonged period, federal debt held by the public—currently about 70 percent of GDP, its highest mark since 1950—would continue to rise much faster than GDP. Such a path for federal debt could not be sustained indefinitely, and policy changes would be required at some point.

Forecasting how all this plays out is especially tricky at a time of dysfunctional government and an unusually contentious election season. Meantime, the macro stakes are rising. There’s an assumption that economic policy is focused on favoring growth and keeping the nation out of recession. The track record is, of course, littered with mistakes and failure, although one can argue that those were honest errors and/or the fallout from “normal” political affairs. The danger that awaits now, however, may be the first time that government actively plays a role in tipping the economy into recession. Is Washington really going to let that risk rise?
“You can call this a fiscal cliff. You can call it Taxmageddon as others have done,” says Sen. Orrin Hatch, a Republican from Utah. “Whatever you call it, it will be a disaster for the middle class. And it will be a disaster for the small businesses that will be the engine of our economic recovery.”
For the moment, at least, the public is unconcerned (or unaware?). Economic confidence hit a new post-Great Recession high last week, according to Gallup. That’s not surprising, given the ongoing expansion in the broad economy, according to the April reading on the Chicago National Fed Activity Index.
The question before the house: Will events in Washington derail whatever positive momentum bubbles in the economy?