As the deficit reduction debate drags on, talk is growing in Washington about allowing the US to go over the fiscal cliff, triggering $600bn of spending cuts and tax increases in the new year. Some are suggesting that doing so would not be too damaging to the economy. Or even that it would be a good tactical move, providing the new Congress with an incentive to reach a significant budget accord.
Such thinking seriously underestimates the cost of going over the cliff. The willingness to contemplate failure is perhaps understandable. The Congressional Budget Office has estimated that while the economy would shrink at an annualised rate of 1.3 per cent during the first half of next year were the cliff not averted, growth would rebound to 2.3 per cent in the second half of 2013.
But the CBO estimates are far too conservative. The fiscal drag implied by going over the cliff would subtract about $1tn (6.3 per cent of gross domestic product) from projected growth over the 18 months from January 2013. Given the consensus forecast for 2 per cent growth next year, that leaves a growth rate of -2.2 per cent for 2013. This calculation is consistent with estimates reported in October by the IMF.