Fiscal Cliff Takes Center Stage With Recession Looming

Courtesy of Pragmatic Capitalism:

Some of the highlights of the CBO report are below:

What Policy Changes Are Scheduled to Take Effect in January 2013?

Among the policy changes that are due to occur in January under current law, the following will have the largest impact on the budget and the economy:

• A host of significant provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) are set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009. (Provisions designed to limit the reach of the alternative minimum tax, or AMT, expired on December 31, 2011.)

• Sharp reductions in Medicare’s payment rates for physicians’ services are scheduled to take effect.

• Automatic enforcement procedures established by the Budget Control Act of 2011 (P.L. 112-25) to restrain discretionary and mandatory spending are set to go into effect.

• Extensions of emergency unemployment benefits and a reduction of 2 percentage points in the payroll tax for Social Security are scheduled to expire.

What is the Budget and Economic Outlook for 2013?

CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:

• The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.

• Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.

• Because of the large amount of unused resources in the economy and other factors, the rate of inflation (as measured by the personal consumption expenditures, or PCE, price index) will remain low in 2013. In addition, interest rates on Treasury securities are expected to be very low next year.

While I have previously called for a US profit recession, currently taking place, I’ve remained in the camp (with PragCap) that held current budget deficits are large enough to stave off a recession. Next year, however, is a whole different ball game. The CBO’s baseline comes surprisingly close to matching my own expectations for 2013. There will be some form of compromise in Congress (there always is), but I simply don’t believe the political will or desire exists to prevent a substantial shrinking of the deficit.

If the CBO baseline is reasonably accurate (or understates the intended reduction), I fully agree that the US will enter recession in 2013 (or late 2012 depending on Congressional actions). Oddly enough, I also think this outcome will lead to a larger deficit than expected as counter-cyclical policies take hold. The US recession will probably be shallow in that case, absent a major shock from Europe or China, where risks remains high. Markets and politicians have largely ignored this issue to date, but soon enough it will take center stage.