Washington elites have spent much of the last three decades getting hysterical about budget deficits, but they are outdoing themselves in the current budget stand-off which they labeled as the "fiscal cliff". Their story is that scheduled increases in taxes at the end of 2012, coupled with mandated cuts in spending, will send the economy tumbling into recession if Congress doesn't take action before the end of the year.
 

The horror story associated with this 1 January deadline depends on fundamentally misrepresenting reality. There are projections from the Congressional Budget Office and other independent forecasters that show the combination of tax increases and spending cuts would chop more than 3.5 percentage points off GDP growth. This hit would mean a contracting economy and push the unemployment rate back over 10%.

However, the part that is generally downplayed in this genuine horror story, or left out altogether, is that the projection of a recession is not based on missing the 1 January deadline. The projection assumes that the higher tax rates and lower spending levels are left in place throughout the year – a scenario that almost no one considers plausible.
 

A more realistic scenario would be that Congress and the president will quickly reach an agreement in the new year, extending most of the tax cuts and limiting the decline in spending. This would mean that some people may see some extra taxes deducted from a paycheck or two, but they would get this money refunded to them in subsequent checks. The predicted effect on consumption would be close to zero.

On the spending side, President Obama has enormous control over the pace of spending. If he believes that a deal is imminent, there is no reason for him to cut spending below a pace that would be consistent with the amount that he expects to agree to with Congress.

In other words, the direct hit to the economy from missing the 1 January deadline is close to zero.

However, the deficit crisis mongers are a persistent bunch. If they can't make a case based on economics, they turn to their good friend "the confidence fairy". The story presented to us in a column in the Washington Post was that business people will get freaked out if there is no deal by 1 January and that financial markets will panic. New York Times columnist David Brooks pushed the same line in a column earlier in the week.
 

This sort of warning, coming from people who have a near-perfect track record in being wrong on everything they say about the economy, would ordinarily be laughable. Unfortunately, these warnings come from people who have prominent positions in national policy debates. Therefore, it is likely that such warnings will be taken seriously.

The deficit hawks want to promote a sense of crisis because it is essential to advancing their agenda. If the 1 January deadline passes, the political ground shifts to those who just want to see an end to the Bush tax cuts for the wealthy: after 1 January, the Bush tax cuts will have expired.

This means that when President Obama pushes his campaign pledge to keep in place the Bush tax cuts for 98% of households, he will be asking Congress to lower taxes for 98% of the people, not to raise them for 2%. It would be difficult even for a Republican Congress to refuse this tax cut.

The deficit hawks desperately want to avoid this outcome, both because many do not want to see taxes rise on the wealthy, but also because they see a crisis over this fiscal stand-off as providing an excellent opportunity to cut social security and Medicare. For this reason, the deficit hawks are doing everything they can to convince the public that waiting until after 1 January to reach a deal would be an economic disaster.

Of course, none of us can predict the future with certainty, which means it is possible that the financial markets really will panic and economy will tumble if we miss the 1 January deadline. However, in addition to the horrible track record of the "crisis crew", there is another important consideration to keep mind. The immediate impact of fluctuations in financial markets on the economy is quite limited.

The economy does not respond to the daily ups and downs of the stock market. Even the crash of October 1987 did not prevent the economy from growing at a 7% annual rate in the 4th quarter of the year. This means that if the markets are, in fact, dominated by Chicken Littles who run for cover if the 1 January deadline is missed, then it is likely that more sober-minded investors will restore stability in the next month or two after a deal is reached and the world is still standing. The net effect on the economy is likely to be minimal, even if some fortunes may have been made and lost with the volatility.

The real bottom line is whether the country will allow the deficit hawks to scare us into a deal that we would never make under normal circumstances. We'll know the answer to this one in six weeks' time.  

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