UMD Study: Fiscal Cliff Could Trigger Deep Recession, Fear of Cliff Has Cut GDP Already

COLLEGE PARK, Md. - The so-called "fiscal cliff" has already begun dampening the U.S. economy - even before it officially kicks in - and by year's end will have cut 2012 GDP an estimated six-tenths of one percent, says a new study conducted by researchers at the University of Maryland's Interindustry Forecasting Project (Inforum).

The study, called Fiscal Shock: America's Economic Crisis, is one of the first to look beyond the first year effects of the combined federal spending cuts and tax increases. It projects an escalating impact into 2014 and beyond, as "multiplier" effects of fiscal contraction kick in.

At its worst, the study says that, compared to a baseline forecast of moderate growth, six million jobs could be lost. The unemployment rate could reach 11 percent, and real personal income could drop nearly 10 percent.

"The fiscal cliff could produce a steeper growth drop than other predictions suggest," says study author Jeff Werling, Inforum executive director at the University of Maryland. "One of the most important lessons learned since the financial crisis is that when consumers are bent on reducing debt burdens, and short term interest rates are stuck at zero, then fiscal multipliers are particularly large. We saw this with the positive effect of the stimulus program through 2010, and we certainly have noticed this with the disastrous austerity programs across Europe."

The study, conducted by Inforum with the support of the National Association Manufacturers, predicts the likely outcome of so-called "Sequestration" - automatic, across-the-board, federal defense spending cuts required by Congress, along with the expiration of a number of tax cuts.

"The mere anticipation of the fiscal cliff has already hurt the economy, and the meter is running," Werling adds. "Going over the cliff would completely undermine the fragile recovery and the effect would snowball at least through 2014. Full recovery could take up to a decade. Our numbers suggest that failure to reach a resolution will have a deeply punishing effect on the nation."

Key study findings:

• Combined, the pending increase in federal tax increases and expenditure reductions total over 3 percent of GDP in 2013.
• Because of the uncertainty surrounding fiscal policy, consumers and businesses already have reduced spending significantly, cutting perhaps 0.6 percentage points of annualized GDP growth over 2012.
• Compared to a baseline of moderate growth, the level of GDP will be at least 3 percent lower in 2013 and almost 5 percent lower in 2014.
• By 2014, the fiscal contraction will result in the loss of almost 6 million jobs compared to the baseline, and the unemployment rate could reach over 11 percent.
• Given the increase in tax rates, real personal disposable income will drop almost 10 percent by 2015, compared to the baseline.
• It will take most of the decade for economic activity and employment levels to recover from the fiscal shock. In addition, there is a significant threat that another recession could deal a substantial blow to long term economic potential, permanently reducing living standards in the American economy.

Next Steps

Werling urges a so-called balanced approach to avoiding further pressures as the economy nears the fiscal cliff. The key, he says, is to absorb cutbacks more slowly.

"It is clear that resolving the federal deficits will require both significant discretionary spending cuts and revenue increases that accompany tax reform," Werling explains. "Ultimately we will have to restructure entitlement programs as well. But such measures can and must be accomplished steadily and gradually over time so as not to unduly harm near term economic growth."

He adds: "Instead, we have engineered a fiscal train wreck that would have enormous consequences to economic growth now and into the future. We need to change course as soon as possible."

Inforum was founded 45 years ago in the Department of Economics and is dedicated to improving business planning, government policy analysis and the general understanding of the economic environment.

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Contact Information:

Jeff Werling
Executive Director
Inforum
301 405-4607
werling@econ.umd.edu
www.inforum.umd.edu

Inforum