The Congressional Budget Office has released an updated analysis of the economic effects of budget options.

Nobel prizewinning economist Paul Krugman, has noted on the weekend that the “fiscal cliff” is a political crisis, not an economic crisis. He is right about this. Normally a US election like the one we have just had, would remove political uncertainty. Barack Obama was re-elected with 51.4 per cent of the popular vote (our forecast the week before based on the Iowa Electronic Market was 51.9 per cent). This election would normally be followed by a stockmarket rally because uncertainty had been settled. Instead the stockmarket remains soft. This is because the uncertainty of the fiscal cliff remains.

On 8 November, the non-partisan Congressional Budget Office (CBO) released updated estimates of the economic effects of various solutions to the fiscal cliff. They say that if nothing is done, GDP in 2013 will drop by 0.5 per cent because of fiscal tightening. Unemployment would rise to 9.1 per cent. However, they note that the long term effects would be positive because the net debt to GDP ratio of the United States would be set on a downward path. Still, neither political party would want to be responsible for a recession in the short term.

Possible Solutions

The CBO says the following possible actions would reduce the size of the recession by the following amounts:

1. Eliminating the automatic budget cuts scheduled to reduce discretionary and a mandatory spending starting on 1 January and maintaining Medicare payments (see footnote) for physician services at the current level would boost real GDP by 0.75 per cent.

2. Extend the Bush tax cuts (to income tax) and indexing the alternative minimum tax (income tax) would boost GDP by 1.5 per cent.

3. Doing both of the above would boost GDP by 2.25 per cent. The result would be to lift the GDP rate from a recession of -0.5 per cent to a modestly healthy +1.75 per cent. This is near our mostprobable short term scenario.

Other Possible Solutions

Other solutions may add or take away from the package above in the following ways:

1. Extending all expiring income tax provisions other than the cut in the payroll tax and indexing the alternative minimum income tax for inflation – except for allowing the expiration of lower income tax rates above $250,000 for couples and $200,000 for single tax payers, would boost real GDP by around 1.25 per cent. This gives us a total GDP result of 1.5 per cent.

2. Extending the current 2 per cent cut in payroll tax and the current emergency unemployment benefits would boost real GDP by 0.75 per cent. This gives us a total GDP result of 2.0 per cent. The combination of these changes plus all of the changes in “Possible Solutions” would boost real GDP by 3 per cent. This gives us a total GDP result of 2.5 per cent.

Conclusion

The fiscal cliff is a political crisis, not an economic crisis. Neither political party wants to be responsible for a short term recession. Still the range of possible results for US GDP growth could be anywhere from -0.5 per cent to +2.5 per cent in 2013.

We think the most probable result lies near 1.75 per cent. By early January much of this uncertainty will be removed.