Analysis: Fiscal cliff could hit economy harder than many expect

Sun Oct 28, 2012 1:57pm EDT
 
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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.   Continued...

 
A U.S. flag decorates a for-sale sign at a home in the Capitol Hill neighborhood of Washington, August 21, 2012. REUTERS/Jonathan Ernst