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Analysis: Fiscal cliff could hit economy harder than many expect

By Jason Lange

WASHINGTON (Reuters) - The United States runs the risk of a recession far deeper than many investors and policymakers may think if lawmakers fail to avert looming tax hikes and cuts to public spending.

Absent action by Congress, the country will face the so-called fiscal cliff at the start of next year, a combination of lower spending and higher taxes that is expected to extract about $600 billion from the economy.

Many economists think every dollar of deficit reduction will subtract nearly the same amount from economic growth.

By that measure, the current course could cause the economy to contract by 0.5 percent in 2013, according to estimates by the Congressional Budget Office (CBO) that have been largely embraced by Wall Street and the U.S. Federal Reserve.

But research by economists in academia and at the International Monetary Fund suggests a dollar of deficit reduction could drain as much as $1.70 from the economy, making the prospective belt tightening much more dangerous.

"You can take that 0.5 percent contraction and double it," said Barry Eichengreen, an economist at the University of California, Berkeley.

These researchers suspect fiscal contractions take a bigger-than-normal bite from economies when interest rates are very low, as is the case at the moment in the United States and in much of the developed world.

One explanation, Eichengreen said, is that when rates are higher, central banks can easily lower them to provide a counterweight to austerity. But when rates are near zero, as they are in the United States, it's harder to ease the pinch.

Historical data suggests higher taxes or lower government spending normally lead households to cut back on purchases only modestly. In the three decades through 2009, a dollar in government austerity would suck only half that from the economy, according to IMF research published this month which examined fiscal policy in 28 countries.

But economies around the world appear to be acting differently since the Great Recession. The IMF said it appeared that every dollar of recent fiscal consolidation has drained anywhere from $0.90 to $1.70 from economies.

The IMF said this suggested central banks have been having difficulty offsetting the impact from tighter budgets.

That could well be the case in the United States as well. The Fed pushed overnight rates to near zero in December 2008 and has resorted to the unconventional policy of purchasing government and housing-related bonds to revive the economy.

The central bank's chairman, Ben Bernanke, has acknowledged he would not be able to fully offset the pain if the economy runs into the "fiscal cliff."

With the U.S. jobless rate at 7.8 percent and the recovery still shaky, the possibility of a greater-than-expected hit to activity might be food for thought for lawmakers, who will be looking to cut some sort of deal on the budget before year end.

LET'S MAKE A DEAL

There's little room for error. Forecasters expect economic growth next year of just 2.1 percent, with the jobless rate edging down only slightly.

As it is, economists believe even the level of danger outlined by the nonpartisan CBO will be enough to propel lawmakers, who are deeply divided over taxes and spending, to reach an accord, although signs have yet to emerge that a deal is starting to gel.

"No political party wants to go down in history as the one that triggered the second half of the worst recession since the Great Depression," said Paul Dales, an economist with Capital Economics in London.

Capital Economics expects Congress will allow just under $100 billion in fiscal tightening, which it thinks would knock the same amount off gross domestic product (GDP).

Yields on U.S. government debt suggest investors as a whole are betting on even less tightening next year, according to research by analysts at Bank of America.

Bank of America itself expects lawmakers will allow much of the fiscal cliff to transpire, leading to about $325 billion in budget tightening, enough in their view to stall job growth.

Like Capital Economics and many other research units in the financial world, Bank of America presumes every dollar of tightening would drain the economy by about the same amount, although it says a bigger effect is possible.

"The economic impacts could be worse than our baseline assumptions," said Michael Hanson, an economist with the bank in New York.

Eichengreen and others who have studied economic data from the Great Depression, another time central banks were constrained, found the drag from a tightening of fiscal policy was much higher at the time. Eichengreen thinks currently the so-called multiplier is about 1.7, in line with the upper range of the IMF's estimate.

If he is right, even avoiding just half of the fiscal cliff would not be enough to steer the economy clear of recession.

Earlier this month, Senate Republican leader Mitch McConnell argued for not "a penny less" than $109 billion in budget tightening next year. But even a tightening in the budget of that magnitude would have an outsized effect if Eichengreen and others are on the mark.

"It would make more sense to assure a strong self-sustaining recovery before embarking on significant fiscal consolidation," Goldman Sachs economists said in a recent report that summarized research pointing to heightened risks of budget slashing.

(Reporting by Jason Lange; Editing by Tim Ahmann and Sandra Maler)

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