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.