As it has been reported ad nauseum, in the absence of a legislative deal between the White House and Congress, on January 1, the U.S. government will go over the "fiscal cliff." Despite all of this reporting, the details about what the fiscal cliff entails have been glossed over by everyone from John Boehner to Warren Buffett. So, here is a simplified breakdown.
If the fiscal cliff remains unresolved, the U.S. economy can expect a net contraction of GDP in the first half of 2013 and growth averaging around 1% for the whole year. The labor market would suffer a similar setback with the unemployment rate rising back above 8%, toward the 8.5% mark, rather than continuing its current downward trend.
The essential components of the fiscal cliff that have the largest impact to both GDP and tax payers are the expiration of the "Bush Tax Cuts," the defense spending "sequester," the expiration of the payroll tax holiday, and the expiration of extended unemployment benefits. A complete breakdown of the tax increase and spending cut implications for GDP can be found in the table below, produced by Macroeconomic Advisers.
This analysis demonstrates just how severe the impacts of the fiscal cliff would be in the first half of 2013. However, it does not show that if we endured these tax hikes and spending cuts, the government could be in surplus as early as 2018 and the debt-to-GDP ratio could fall below the 60% mark in 2021. While this sounds like a rosy scenario, it negates the fact that the going over the fiscal cliff would likely restrain GDP growth and increase unemployment rates for the next decade. Additionally, although the U.S. government would be nominally solving the deficit issues, the lack of ability to compromise would send a negative signal to global markets about the sustainability of U.S. fiscal policy.
Over the last two weeks, it seems that equity markets have decided that we are unlikely to go over the fiscal cliff. While I generally agree with this sentiment, I also don't expect a long-term solution in the near future. So, for all the conciliatory language coming from Washington in an effort to calm markets, I believe a lot of it to be cheap talk. The most likely scenario is a short-term, can-kicking scenario to blunt the worst of the cliff while a longer-term solution is negotiated. Such a short-term agreement is likely to bolster markets briefly, before they drop dramatically in the absence of a longer-term solution. Essentially, I expect brief irrational exuberance followed by disappointment about the details, leading to prolonged malaise and continued doubt about long-term U.S. fiscal health.