Updated Wednesday, November 26, 2014 as of 7:42 AM ET

Cliff Analogy Overstates Immediate Harm to Economy

While the U.S. Congress views the convergence of more than $600 billion in tax increases and spending cuts set for Jan. 1 as a “fiscal cliff,” the metaphor misses the economic reality of what could follow.

The image popularized by Federal Reserve Chairman Ben S. Bernanke could give way to a series of compounding events if congressional leaders and the president fail to compromise.

“Cliff conjures up Wile E. Coyote, and January comes, and all of a sudden you plunge into a deep recession inevitably and it all happens fast,” said Chad Stone, chief economist at the Center on Budget and Policy Priorities in Washington. “That’s not the way things would unfurl.” He said he prefers the term “fiscal slope” to describe how the effects would accumulate gradually during 2013.

Congress created the conjoined deadlines on tax and spending policy as a way to prod itself to resolve long-running disputes on fiscal issues. The cliff metaphor has reinforced the need for action, shaping the debate for more than nine months and increasing pressure for Congress to avert at least some of the tax-and-spending changes.

Stalled Talks

While negotiations have stalled over President Barack Obama’s demand for higher tax rates for top earners and congressional Republicans’ insistence on structural changes to entitlement spending, a Republican aide says those talks will narrow to conversations between Obama and House Speaker John Boehner. Failure to reach an agreement by year’s end could mean, in keeping with the metaphor, going over the cliff.

The Congressional Budget Office estimates that the U.S. would probably enter a recession in the first half of 2013 if Congress doesn’t act to avoid the tax increases and spending cuts. The unemployment rate would climb to 9.1 percent in the fourth quarter of 2013 from 7.9 percent in October 2012, CBO projects.

Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC, said critics of the cliff image understate the potential for business investment to decline and for financial markets to react negatively to legislative gridlock.

“The folks who argue that it’s a fiscal slope are really ignoring the psychological impact that it would have on the business community,” Dutta said. “We face a cliff in the sense that this would be a notorious political failure if Congress failed to avert a recession, because that’s effectively what the government is threatening right now.”

Financial Markets

Financial markets are operating under the assumption that Congress will reach a deal by the end of the year or early January, said Alec Phillips, a political analyst and economist for Goldman Sachs Group Inc. in Washington. There is “not a lot of indication right now that the market is expecting an adverse outcome,” he said.

“People who describe it as a slope have a point, which is that the world doesn’t necessarily end on Jan. 1, if people assume the issue will be fixed very soon,” Phillips said. “At the same time, it seems pretty clear that if they don’t address the fiscal restraint that’s built into current law within a reasonable period of time, a cliff and a slope are essentially the same thing. The only difference is just the angle.”

When lawmakers have expressed optimism about a deal, stocks have risen. Prices have dropped when they say negotiations are stalled, giving hints at the potential for market declines if talks fail.

Standard & Poor’s

The Standard & Poor’s 500 Index declined 0.5 percent in three minutes on Nov. 29, erasing an earlier rally, after Boehner said “no substantive progress” had been made toward a deal. Bond markets have gained on pessimistic news. The benchmark 10-year Treasury note yield fell for the fifth of six weeks ending Nov. 30 as Obama warned that day of “prolonged negotiations” ahead on deficit reduction.

To bolster his point that the cliff is more of a slope, Stone points to the components of the scheduled fiscal contraction and how they take effect over time. Those effects can be reversed if a deal is reached early in 2013, he said. There are several other fiscal deadlines in 2013 that could push Congress to act, including the need to raise the $16.4 trillion debt limit.

If Congress doesn’t act, the policy changes include higher income tax rates at all income levels, the end of a 2 percentage point cut in the payroll tax, higher tax rates on capital gains, estates and dividends, and automatic spending cuts, about half in defense programs.

Paycheck Withholding

Most of the effects would occur over the course of the year. Because most taxes are collected through paycheck withholding, only a fraction of the effect occurs each week or month.

Get access to this article and thousands more...

All Bank Investment Consultant articles are archived after 7 days. REGISTER NOW for unlimited access to all recently archived articles, as well as thousands of searchable stories. Registered Members also gain access to exclusive industry white paper downloads, web seminars, blog discussions, the iPad App, CE Exams, and conference discounts. Qualified members may also choose to receive our free monthly magazine and any of our daily or weekly e-newsletters covering the latest breaking news, opinions from industry leaders, developing trends and growth strategies.

Already Registered?

Comments (0)

Be the first to comment on this post using the section below.

Add Your Comments:
Not Registered?
You must be registered to post a comment. Click here to register.
Already registered? Log in here
Please note you must now log in with your email address and password.

Already a subscriber? Log in here