CBO Projects a Recession -- But How Deep?

We've warned many times before that going off the fiscal cliff would throw the economy into a double dip recession. With CBO's updated budget and economic outlook (see our full analysis here), we now have a pretty good picture of what would happen -- and it isn't pretty.

CBO's latest economic forecast shows the economy shrinking at an annualized rate of 3.9 percent in the first quarter of 2013 and 1.9 percent in the second quarter. Beyond the first half, the economy would grow modestly at 1.2 percent in the third quarter and 2.6 percent in the fourth quarter, leading to a 0.3 percent contraction for the year as a whole. Unemployment, as a result of this contraction, would increase from a low of 8.2 percent to a high of 9.1 percent at the end of 2013.

To put this in context, the United States has had 26 quarters of negative economic growth since 1960. This contraction would be larger than 18 of them and smaller than only 8. It would not be nearly as severe as the 9 percent contraction at the end of 2008 or the 8 percent contraction during the second quarter of 1980, when the economy entered the first of two recessions in the early 1980s.  But it would be larger than the peak contractions in the financial and real estate tumult of the early 1990s and the bursting of the dot-com bubble in 2001.

Source: BEA, CBO

Some have pointed out that the fiscal cliff may be more like a slope in that the economy won't tank instantly when the new year comes around. This may be so since fiscal changes take time to work their way through the economy. However, if we accept both the "fiscal slope" argument and CBO's projections, that would mean that February and March would have even greater contractions than the 3.9 percent drop-off. For example, if growth were 0 percent in January, it would mean that the contraction would have to be 5.9 percent in the remaining two months.

It is notable, though, that CBO's forecast for the cliff has deteriorated over time. In January, they projected stagnation, if not a borderline recession. In their report on the fiscal cliff in May--which incorporated the payroll tax cut, doc fix, and unemployment insurance into the cliff--they predicted a recession with a first half of 2013 contraction of 1.3 percent. Now, they predict a 3 percent contraction. It's not exactly clear why their outlook is much worse this time than in May, perhaps due to fundamentals in the economy being weaker than expected. That being said, it's clear now that recession is a likely possibility.

Source: CBO, BEA
Note: 2011 data are actuals from BEA

But as The Wall Street Journal's Neal Lipschutz points out, CBO's projections don't exactly make a strong case for simply averting the cliff without offsets. Growth in 2013 would be positive but below two percent in the Alternative Fiscal Scenario (AFS), which avoids most of the fiscal tightening. We have noted before that simply undoing the cliff policies would not be a very cost-effective form of stimulus, and this projection bears that out. Furthermore, the AFS would damage the economy in the long term as excessive debt crowds out private savings. Thus, it's a scenario that provides for modest growth in the short term and disaster down the road.

A gradual and smart fiscal plan, as we have said many times, should avoid the cliff and excessive debt. Doing so could also leave room for short-term boosters for the economy. In short, the ideal plan would be better than both scenarios in both the short term and the longer term.

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