The Fiscal Cliff

September 2012 Sudeep Reddy The Wall Street Journal wsj.com/economics Twitter: @Reddy

Measuring the Economy
The 15-Second Version

Gross domestic product = total value of goods and services produced in an economy
GDP = consumer spending + business investment + government spending + net exports

Annual U.S. GDP = $15+ trillion Current annual growth rate = 1.5% to 2% Long-run “trend” growth = 2.5% to 3%
(depends on population, productivity, investment, education, technological change, etc.)

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U.S. GDP

Assessing U.S. Debt
The 30-Second Version U.S. deficit (annual shortfall) peaked at almost 10% of GDP Goal for sustainable deficit = less than 3% (pace of GDP growth)

U.S. gross debt = $16 trillion (almost 100% of GDP) Debt held by the public = $11.3 trillion (72% of GDP)

Unsustainably high debt can lead to slower growth, as borrowing costs rise across the economy. Reinhart/Rogoff: 90% debt-to-GDP suggests higher risks to an economy. Median growth slows by 1% annually. (Among the caveats: Correlation does not equal causation. This isn’t a red line for a bond-market revolt. The U.S., with a reserve currency, is a very special case.)

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Key Fiscal Cliff Components
• • • • Higher personal/capital gains tax rates End of payroll tax holiday Sequestration cuts from 2011 End of extended unemployment benefits

Also: Cuts in Medicare payment rates for physicians higher-earner investment tax hikes under ACA higher estate taxes

Fiscal Cliff Effects
• Economy: cutting government spending and consumer spending (due to their higher taxes) lowers GDP. The 2013 recession would cut real GDP at a 2.9% pace in 1H 2013 (CBO). Growth could recover afterward, if no self-reinforcing downward spiral takes hold. • Deficit: The higher taxes and lower spending, however, would cut the deficit to $640 billion (from $1.1 trillion) if maintained. • Credit rating: Without deficit reduction, Moody’s & Fitch rating firms could cut the U.S. AAA rating. S&P could lower its AA+ rating further.

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Value of Key Components

Source: Morgan Stanley

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