The fiscal cliff “catch-22”

Where we stand today

The CBO report on the “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013” states that tax increases will reduce the 2013 deficit by $399 billion and sequestration spending cuts for 2013 will reduce  the deficit for 2013 by another $208 billion. 

These tax hikes and spending cuts total $607 billion and represent money that will be pulled out of the economy in 2013. The impact of these actions is a reduction in GDP.     The CBO estimates that the first half of 2013 will result in a negative GDP growth of        -1.3%. They project GDP growth for the second half of 2013 at +2.3% resulting in an annual growth in GDP of a mere 0.5%. Under the CBO projection and based on their own positive assessment of current trends in the housing market, we still go into recession in the first half of 2013.

The CBO offers another projection based on removing all deficit reduction measures through legislative action in late 2012.  Under that scenario, they project GDP growth in 2013 of 4.4%. 

The CBO readily admits that these forecasts are tentative at best. There are a number of factors that are beyond the control of Congress that may result in added downside pressure on GDP in 2013.  The CBO states:

It bears emphasizing, however, that economic forecasts are very uncertain. Many developments, including the evolution of banking and fiscal problems in Europe and the speed at which the U.S. housing market improves, could cause economic outcomes to differ substantially, in one direction or the other, from those CBO has projected.

The following bullet points represent a very short list of events and circumstances that could negatively impact the CBO forecast:

  • Assuming that we continue on the present trajectory, going over the fiscal cliff will leave us far short of a balanced budget. If the current deficit spending level of approximately $1 trillion annually is reduced by the scheduled tax hikes and spending cuts by roughly $600 billion, we will continue to add to the debt at the rate of $400 billion a year.
  • It is unlikely that unemployment numbers can remain at current levels as companies scramble to cut costs further in anticipation of shrinking top line sales thereby reducing the tax base further and expanding the deficit.
  • Top line sales are almost certain to shrink further from the impact of the contracting economies in Europe and China. 
  • The $400 billion deficit could double in spite of tax hikes and spending cuts if interest rates rise. A 2% increase in interest rates would result in carry cost of current debt going up by another $320 billion.

If we take the “kick the can” approach and extend tax cuts and defer spending cuts, we will continue to add to the deficit by $1 trillion a year. Even if we assume an optimistic 4% growth in GDP over the next four years and no change in carrying costs of debt, our debt will climb to approximately $20 trillion and GDP will climb to approximately $18.7 trillion — a debt to GDP ratio of 107%. 

The scenario above ignores the impact of a recession or an economic slowdown.  Consider that even if we were to avoid recession and GDP growth were to somehow grow at a 2% clip over the next four years, GDP would only grow to $17.6 trillion. Add to that scenario a carry cost increase of 2% resulting from an increase in interest rates that seems possible despite the Fed’s efforts to prevent an interest rate spike. Under that scenario we would end up reducing the $600 billion in deficit reduction by $320 billion without adjusting for the compound effect.

In other words debt would increase by an average of $720 billion a year even after the tax hikes and spending cuts leaving us with a debt of $18.8 trillion and a GDP of $17.6 trillion — a debt to GDP ratio that would still end up at 107%. This scenario completely ignores the impact of increased unemployment that would shrink the revenue side of the equation by reducing the tax base. It also ignores the acceleration in spending cuts that will occur in future years under the sequestration arrangement. 

The bottom line is that even if we do go over the cliff by ending tax cuts and implementing the sequestration spending cuts, we are not really achieving a great deal.  It is entirely possible that even with these austerity measures, we still end up with $1 trillion deficits in future years. There is a legitimate case to be made for the idea that even going over the cliff is not enough.

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