The Fiscal Cliff Will Drive the U.S. Into Recession

Last summer, as part of its agreement to end the debt-ceiling debate (debacle?), Congress strapped a bomb to the economy and set the timer for January 2013. Into it they packed billions of dollars of mandatory discretionary spending cuts, timed to go off at exactly the same time a number of tax cuts were set to expire.

The congressional deficit supercommittee had a chance to disarm the bomb last fall, but of course it didn’t. And so the timer has kept ticking. The resulting double-whammy explosion of spending cuts and tax increases will likely send the economy careening off a $600 billion “fiscal cliff.”

How bad will the damage be? The folks over at Goldman Sachs have crunched the numbers, running the equivalent of an economic crash test, and it looks grim. If Congress does nothing, the U.S. will almost certainly go into recession early next year, as the combo of spending cuts and tax hikes will wipe out nearly 4 percentage points of economic growth in the first half of 2013, according to research by Goldman’s Alec Phillips, a political analyst and economist. Since most estimates project the economy will grow only about 3 percent next year, that puts the U.S. solidly in the red.

As if that’s not depressing enough, Phillips places the odds of this happening—that is, Congress doing nothing (at least temporarily)—at 35 percent. A happier outcome, which Goldman refers to as its base case, plays out like this: Congress extends the 2001 and 2003 Bush-era tax cuts and also delays most of the spending cuts past 2013. Unemployment benefits, set to expire at the end of this year, are phased down rather than fully expiring at the end of 2012. Phillips predicts a 20 percent to 40 percent chance of something like this happening, depending on the length of time Congress chooses to extend things.

Still, that scenario would drag down growth by about 1 percentage point. The best-case scenario, that Congress reaches a “grand bargain” of sorts—plugging tax-code loopholes and addressing the long-term deficit with spending cuts and new tax revenue—appears the least likely outcome. Phillips puts the odds of Congress striking such a deal at just 5 percent.

This whole exercise revolves around the wrestling match between reducing the debt and boosting the economy, two things that appear to be mutually exclusive these days. The argument being made by those calling for significant spending cuts, and thereby significant debt reduction, is that sooner or later the world’s capital markets will punish the U.S. for its profligate ways by raising the cost of borrowing. This is what’s happening in Spain right now.

The irony here is that, as far as the U.S. is concerned, the evidence doesn’t bear that out. Granted, we have only a sample size to go on, but last summer after Standard & Poor’s downgraded the U.S. credit rating for the first time ever, the immediate result was that Treasury rates fell to near record lows. The U.S. already has among the cheapest borrowing costs in the world. Will reducing our debt really lower them that much more? Not likely, especially if it derails the tepid recovery.

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