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'Fiscal cliff' could derail US recovery

May 22 2012 14:49 Reuters

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Washington - A sharp fiscal contraction next year could derail the US economic recovery, the Organisation for Economic Cooperation and Development warned on Tuesday as it urged the government to move only gradually to tighten its budget.

A wave of US spending cuts and tax hikes - dubbed the “fiscal cliff” - are set to take effect in January unless politicians agree on ways to delay at least some of them.

Bush-era tax cuts and jobless benefits for the long-term unemployed are both set to expire. In addition, $1.2 trillion in across-the-board reductions in spending on federal programs would kick in as a result of Congress’ failure last year to find a comprehensive deal to cut the budget deficit.

In its latest economic outlook, the OECD said these actions would mark an ill-timed U-turn in fiscal policy given the still-fragile health of world’s largest economy.

“The programmed expiration of tax cuts and emergency unemployment benefits, together with automatic federal spending cuts, would result in a sharp fiscal retrenchment in 2013 that might derail the recovery,” the OECD said.

It did not specify what the impact on US gross domestic product would be if all the tax cuts lapsed and all the planned spending cuts went into force at the same time.

Wall Street economists forecast that fiscal policy could tighten by about $600bn next year, or about 4% of GDP, if lawmakers fail to reach an agreement. Goldman Sachs estimates the “fiscal cliff” could shave nearly 4 percentage points from GDP in the first half of 2013.

Most economists, however, expect lawmakers to find a way to soften the blow.

In its forecasts, the OECD said the US economy should grow 2.4% this year and 2.6% in 2013. Those projections assume the budget deficit is cut by 1% and 1-1/2% of GDP, respectively, this year and next.

The United States has run budget deficits topping $1 trillion for three straight years, and it is on course to do so for a fourth.

Drag on growth

“This smoother and more gradual pace of consolidation would greatly reduce the risks of derailing the recovery, at little cost to longer-term fiscal sustainability,” the OECD said.

The OECD said authorities could lower the budget deficit by restricting items such as mortgage interest deductions for tax purposes and credits for health insurance. Such moves would also help to reduce market distortions and narrow income inequality, the OECD said.

Given its moderate growth outlook, the OECD said it expected monetary policy to remain accommodative through 2013. The Federal Reserve, which cut overnight interest rates to near zero in late 2008, has said it expects to keep them “exceptionally low” through at least late 2014.

For this year, the OECD forecast the unemployment rate averaging 8.1% - the level hit in April. It expects the rate to drop to 7.6% in 2013. The OECD warned that persistently high long-term unemployment raised the risk that joblessness could become more intractable.

“On the other hand, the recent momentum in hiring activity may presage a faster recovery of the labour market than projected, which in turn would foster a quicker normalisation in economic activity,” it said.

About 41.3% of the 12.5 million Americans unemployed in April had been out of work for more than six months.

Most Fed policy makers, including Chairperson Ben Bernanke, believe unemployment is mainly due to insufficient demand and can be addressed through monetary policy. 

oecd  |  us economy
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