The US Congressional Budget Office (CBO) recently published a report forecasting the economic impact of the "fiscal cliff," estimating that it would produce a mild recession in the magnitude of about -0.5% of GDP in 2013. Furthermore, the CBO implies in another recently published report that the relatively modest short-term pain caused by the fiscal cliff might usher in long-term gain, including estimates of lower budget deficits and higher economic growth than if tax cuts were extended and budget cuts were not enacted.
As a result, there has been an increase in speculation in the blogosphere and financial media, on both the left and right of the political spectrum, that a fiscal cliff scenario would not be so bad after all. This notion is being cited by partisans, on both the left and the right, as a reason why they can afford to hold fast to their respective negotiating positions.
I am concerned about this development because I believe the CBO estimates are likely underestimating the economic impact of a fiscal cliff scenario by a very large margin. The CBO has provided virtually no background regarding how they arrived at these estimates. This is unfortunate because on a prima facie basis, the estimates seem unsound on theoretical and empirical grounds.
4 Reasons To Fear The Fiscal Cliff
For four reasons, I believe that the CBO's forecasts probably greatly underestimate likely impacts of a fiscal cliff scenario.
1. Tax multipliers. The CBO analysis implies that the combined tax and spending multipliers are slightly below 1.0. There is no theoretical or empirical support for this proposition. In this regard, it is critical to note that two thirds of the fiscal adjustment under the fiscal cliff would come in the form of tax increases. This is important because virtually all recent empirical studies have shown that the tax multiplier is significantly above 1.0. In other words, a $1 increase in taxes would produce a decrease in GDP of significantly more than $1. Ominously and notably, the most recent credible empirical estimates for the tax multiplier, starting but not limited to the pioneering work of Christina and David Romer, have converged at around 3.0! This implies that the tax increases alone brought about by the fiscal cliff could produce a GDP contraction of 8.2%. While I personally doubt that the impact would be this great, the fact is that the empirical and theoretical bases for a very high tax multiplier are quite robust, particularly in the context of an economy operating at significantly below potential.
2. Spending multipliers. The empirical data for spending multipliers is less clear than the data for tax multipliers. In particular, spending multipliers seem to be greatly affected by the type of spending involved as well as the economic and financial conditions under which they are applied. Having said this, the overwhelming weight of theoretical and empirical evidence points to a fairly high spending multiplier when an economy is running at below potential. Thus, in the US at the present time, spending cuts of $1 should be expected to reduce GDP by more than $1.
3. The recent experience of Europe. The IMF has recently acknowledged that they have blundered badly in the past few years in advising European governments with regards to spending and tax multipliers. The IMF has acknowledged using a model that implied the prospect of "expansionary austerity." In other words, they assumed that the tax and spending multipliers were less than 1.0 - and in the medium term even less than 0. Experimentation in Europe with this fanciful idea has turned out to be a disaster. The theoretical reasons should have been clear. The only possible basis for a stimulative effect from fiscal adjustment would have come via lower interest rates and increased investment. The problem is that in highly indebted industrialized economies, there can be no expected stimulative "interest rate effect" from lower market interest rates in response to fiscal adjustment. With interest rates already at the zero bound, and debt levels high, significantly increased stimulative borrowing by businesses and consumers as a result of lower interest rates cannot be reasonably expected. Indeed, the opposite has occurred. The recessionary effects of fiscal adjustment have reduced borrowing, consumption and investment and have caused market interest rates to rise. The US should heed the historical experience in Europe and not go down the same disastrous path.
4. Employment. The CBO forecasts that unemployment will rise to 9.1% under the fiscal cliff scenario. The CBO provides no background whatsoever regarding how they reach this estimate. The rule of thumb used by most economists is that a 1% change in GDP can be expected to produce roughly a 0.7% change in employment. Given that the total fiscal adjustment between 2013 and 2014 totals more than 7% of GDP, an increase in the unemployment rate of only 1% seems quite hopeful.
The empirical and theoretical literature on spending and tax multipliers is some of the most contentious in the economic profession. However, both the empirical data as well as the theoretical views converge greatly when the discussion of multipliers is restricted to conditions in which GDP is significantly below potential. Under such conditions, the theoretical and empirical evidence is pretty clear in favor of the notion that spending and especially tax multipliers are significantly above 1.0.
Furthermore, in light of the recent experiences in Europe, there can be very little room for doubt that the spending and tax multipliers are above 1.0 in highly developed and highly indebted countries where economies are operating below their potential.
If the overall fiscal (tax and spending) multiplier were merely 1.0, the economic impact of the fiscal cliff would be around 3% of GDP in 2013 and 4% in 2014. This would probably imply GDP in the neighborhood of -0.5% in 2012 and around 1.5% in 2014. However, if tax and spending multipliers are used that are more in line with the empirical and theoretical literature on the subject, the economic contraction could be in excess of - -4.0% in 2013 followed by a contraction in the -1.0% range in 2014. Such an outcome would be consistent with recent experiences with fiscal consolidations in Europe under similar circumstances.
Now, please note that I do not actually expect the US Congress and President to push the US economy off of the fiscal cliff. Probabilities are high that some sort of partial mitigation will be agreed to, at least. In fact, I think the prospects of a Grand Bargain are even greater than most are factoring in.
However, due to the recently published CBO forecast referenced, I am concerned that economic and political commentators as well as policy makers are significantly underestimating the likely negative impact of a fiscal cliff scenario.
In my view, the uncertainty surrounding the fiscal cliff, and its potentially dire consequences if it were to materialize, is only one reason amongst many for investors to remain very cautions regarding US equities represented in index ETFs such as (SPY), (DIA) and (QQQ) and stocks such as Apple (AAPL), Oracle (ORCL) and Amazon (AMZN). US stocks, in general, are not particularly expensive in historical terms. However, US equity markets are certainly not discounting any more than a trivial prospect of a fiscal cliff scenario, and they are certainly not discounting the low growth and high macro volatility scenario that the US faces for the next decade (even if the fiscal cliff of 2013-2014 is averted).