CBO warns of deep recession if Congress fails to avert 'fiscal cliff'

By Erik Wasson - 08/22/12 11:52 AM ET

The nonpartisan Congressional Budget Office (CBO) on Wednesday warned the economy will enter a recession next year if the country goes over the so-called fiscal cliff.

In its most dire warning yet about the fiscal cliff, the CBO said the economy would contract by 0.5 percent in calendar year 2013 if the George W. Bush-era tax rates expire and automatic spending cuts are implemented.

Unemployment also would rise from 8.2 percent in 2012 to 9.1 percent next year, the office estimates.

“The stakes of fiscal policy are very high right now,” CBO Director Doug Elmendorf said. He urged Congress to act in September to avoid the fiscal cliff.

“The sooner that that uncertainty is resolved, the stronger the economy would be in the second half of this year,” he said. “Economic growth right now is being held back by the anticipation of this fiscal tightening.”

CBO does not make recommendations to Congress but last year laid out the economic and budget effects of a range of choices for Congress, Elmendorf said.

He added that under current law, there will be 2 million fewer jobs if the fiscal cliff is allowed to take place, and said most of the contraction is due to the tax increases.

The contraction would be very severe in the first half of 2013. CBO sees the economy contracting by 2.9 percent in the first half — deeper than the 1.3 percent negative growth it had seen previously from the fiscal cliff.

To put the figures in context, the economy was contracting at a quarterly rate of about 3.5 percent at the depth of the recession in the early 1990s. The CBO said a recession caused by the fiscal cliff would likely resemble that downturn more than the more recent recession caused by the financial crisis, when the economy contracted at an 8.9 percent rate in the final quarter of 2008.

The gloomy picture of rising debt and weak economic growth marks CBO’s final major report before the November election. The report is a sharp contrast with the 1.1 percent in growth the CBO projected in January for 2013 and 0.5 percent growth it projected in May.

CBO says the fiscal cliff will be worse than it had previously projected and that the “underlying strength” of the economy is weaker.

It said the effects of the fiscal cliff are worse in part because Congress extended a payroll tax holiday in February that is also set to expire in January.

House Speaker John Boehner (R-Ohio) on Wednesday put the onus on Democrats to act on the fiscal cliff. He noted that the House has passed bills replacing the automatic cuts with tailored cuts to mandatory spending such as on food stamps, and extending the Bush-era tax rates.

“Instead of threatening to drive us off the fiscal cliff and tank our economy in their quest for higher taxes, I would urge President Obama and congressional Democrats to work with us to stop the coming tax hike that threatens our economy and replace the looming defense cuts with common sense reforms,” Boehner said.

Congressional gridlock means the risk of Congress doing nothing to prevent the tax hikes and spending cuts is real.

Democrats last month threatened to let the nation go over the fiscal cliff unless Republicans agree to a “balanced” deficit package that includes some tax increases. The GOP has so far doubled down on its insistence that a deficit solution include only cuts to non-defense social spending.

CBO projects a deficit of $1.1 trillion this year, the fourth year of budget shortfalls over $1 trillion. This is a slight decrease from the $1.2 trillion that CBO projected in March.

The report notes that debt held by the public will reach 73 percent of the economy this year, “the highest level since 1950 and about twice the 36 percent of GDP that it measured at the end of 2007.”

The CBO report puts the focus back on President Obama’s economic policies and the fiscal issues that the Republican presidential ticket of Mitt Romney and House Budget Committee Chairman Paul Ryan (R-Wis.) considers its strength. The presidential debate this week has been dominated by a controversy surrounding abortion rights and the remarks of GOP Missouri senatorial candidate Rep. Todd Akin.

As usual, the CBO presents two sets of 10-year economic and deficit projections. One is based on current law and the other is based on what Congress has typically done in the past.

Under the current-law baseline, the deficit next year would shrink to $641 billion.

This assumes that a series of policies known as the fiscal cliff take place. They include automatic spending cuts triggered by the August 2011 deal to raise the debt ceiling; expiration of the Bush-era tax rates; a sharp cut in Medicare doctor payments; and the failure to index the Alternative Minimum Tax for inflation, which would raise taxes for many households.

The $641 billion budget deficit estimate is larger than the $585 billion deficit CBO had projected in January.

Under these CBO assumptions, the government would add $2.3 trillion in deficits over the next 10 years.

Under a current policy baseline in which Congress avoids the spending cuts, passes a “doc fix” and extends the Bush-era rates, the deficit would again top $1 trillion in 2013.

But economic growth would be better. CBO estimates under this baseline that GOP growth would be about 1.7 percent, with unemployment dipping slightly, to 8 percent.

In this scenario, over 10 years nearly $10 trillion would be added in deficits and the debt held by the public would reach 90 percent of GDP — the threshold some scholars consider to be the hallmark of a Greece-style debt crisis.

The White House argued the new report reinforced the president's argument that House Republicans should approve his plan to extend low tax rates for families with annual income above $250,000 while raising taxes on higher annual income. White House press secretary Jay Carney said the GOP was instead choosing to "double down on the same failed policies that led to the economic crisis in the first place."

Carney also said it was Congress's responsibility to act to prevent the spending cuts.

"It’s time to replace these cuts with balanced deficit reduction that asks the wealthiest Americans and largest corporations to go back to the tax rates they were paying under Bill Clinton — back when our economy created 23 million new jobs and a record surplus," Carney said. "But first, Republicans in Washington should do the right thing and pass a bill that extends tax cuts for 98 percent of Americans and 97 percent of small businesses. There’s no reason to wait."

House GOP Conference Chairman Jeb Hensarling (R-Texas) said the CBO report is a reminder of the stakes of the election.

“During an historic employment crisis that will be remedied only by stronger economic growth and more jobs, today’s report is further proof that President Obama has put America on a path of slower growth and fewer jobs," Hensarling said in a statement. “CBO’s report reiterates the sad fact that President Obama’s higher taxes, runaway spending, and debt are endangering our nation’s economy, our national security, and our children’s hope for a better future.”

CBO produced a graphic to illustrate the fiscal cliff. Link is here.

—This story was posted at 10 a.m. and updated at 12:52 p.m.