The perils of cliff-diving

By Douglas Holtz-Eakin
December 6, 2012

The fiscal cliff is a danger to the economy.  Some have argued that cliff diving is benign either because the cliff itself is an illusion – it is really a gentle slope – or because policymakers have the cartoon-like power to reverse going over the cliff without hitting the abyss.

Both arguments miss the key role that would be played by financial markets.  Cliff diving would have a significant impact on financial markets, impairing asset values, exacerbating credit stringency and amplifying the direct effects on the Main Street economy. These effects cannot be “unwound” by retroactively legislating away the fiscal cliff.

Taken at face value, the fiscal cliff is a large negative policy shock.  The tax increases are nearly $400 billion and the spending cuts about $145 billion.  The total, $540 billion is roughly 3 percent of gross domestic product.   For perspective, trend economic growth now appears to be less than 2 percent — but certainly nowhere close to 3 percent.

If one uses the multiplier estimates of Christina Romer and Paul Romer – roughly three – going over the fiscal cliff would trigger a decline in the economy of $1.6 trillion – roughly 10 percent of GDP. This would be biggest year-to-year decline since 1932.

But there are good reasons to take that with a grain of salt, however. First, the size of multipliers is controversial, and they may be much smaller.  But even a multiplier of 1 yields a $540 billion decline – a recession of 3 percent.

Second, the duration of the recession is unclear. If Congress adopted a new fiscal policy quickly, the recession could be short-lived.  So, for example, a 3.5 percent recession at an annual rate that lasted only through January, and was quickly reversed, would be a mere blip on the economy’s growth path.

Taken together, these arguments raise the hope that going over the fiscal cliff could be reversible and have a modest overall effect.  Unfortunately, the potential for significant financial market fallout substantially changes the outlook for cliff diving.

Financial markets react essentially instantaneously.  Hence, the moment it becomes obvious that the economy is going over the cliff – recall the horrific sight of the markets crashing as the TARP vote failed – we should anticipate that equity markets will fall, and the riskiness of various classes of debt will be re-evaluated.

Unlike budgetary moves that can be reversed, these kinds of negative effects on market confidence in the outlook are durable.  Many analysts, for example, attribute at least part of the slowing in the 2nd half of 2011 to a decline in consumer confidence because of the political battle over raising the debt limit.

Thus, if policymakers drive the economy over the fiscal cliff, the pure multiplier analysis on the real economy should be augmented by negative financial market impacts that are potentially quite large and long-lived.

The real danger of a renewed recession raises the stakes on reaching a deal. It even shapes the kind of deal that is desirable.

Congress and the president should reach a grand bargain that trims the future debt – next year.  For now the focus should be on temporarily extending current policy, dodging the cliff dive — and averting a self-inflicted recession.

PHOTO (Top): The Dow Jones Industrial Average on a board at the New York Stock Exchange at the end of the trading day, October 15, 2008. Wall Street had its worst day since the 1987 stock market crash. REUTERS/Brendan McDermid

PHOTO (Insert): A weary trader outside the New York Stock Exchange at the end of trading October 9, 2008. The Dow dropped 678.91 points that day to finish at 8579.19, closing below 9,000 for the first time since 2003. REUTERS/Mike Segar

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