Modeling the Fiscal-Cliff Scenarios

 | Nov 14, 2012 | 4:00 PM EST  | Comments
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Forecasting the economy is one thing. Attempting to do so in an era of political uncertainty, particularly regarding the fiscal cliff, invites an added layer of complexity.

As a portfolio manager, I usually consider several different potential outcomes when determining investment strategy. While we cannot know for sure whether Congress will take us off the cliff, we can look at two potential outcomes -- one if we don't go off, and one if we do. Several research reports outline these two scenarios.

Let's start with the scenario of going off the fiscal cliff -- that is, if lawmakers simply don't do anything (or do very little). The nonpartisan Congressional Budget Office has its own forecast and discussion, which is for economic growth to be 2.9% worse than what it would be otherwise, or a contraction of 0.5% in GDP in 2013 (fourth quarter over fourth quarter). This implies growth of 2.4% without the cliff. Unemployment would rise to 9.1% in this scenario.

Private-sector economists have different forecasts, including Jeff Werling of the University of Maryland and Inforum, who published a report that was circulated by the National Association of Manufacturers. He starts with about the same baseline forecast for GDP without the cliff: 2.6% in 2013. He believes the cliff would reduce the full-year growth to 0.2%, with a contraction in output in the first two or three quarters of the year.

However, Werling is more pessimistic on unemployment. His forecast is for a cliff-scenario increase in unemployment to 10.2% in 2013. Given his view of 1% GDP growth in 2014 (1.9 percentage points less than what it would be otherwise), he sees unemployment increasing further, to 11.4% for that year.

One issue he raises for unemployment is an issue known as "hysteresis" in the labor markets. This academic term describes the simple concept that long-term unemployed people may see a degradation of their skills the longer they are without work, leading to chronic unemployment and/or lower labor market productivity if and when they are rehired. This may keep unemployment elevated, as companies eschew a segment of the population that may be unemployed for quite some time.

The above is one scenario, namely going off the cliff entirely. Will it happen? My honest answer is, who knows? If the economy does not go over, here's what it might look like if only some components of the fiscal cliff are adopted, using research from the San Francisco Federal Reserve. Here we see that the researchers expect real GDP to increase roughly 2.5% in 2013 and 3.5% in 2014. (This view includes the estimated effects of Superstorm Sandy.)

That's remarkably similar to the economists' views above, without the fiscal cliff in its entirety. This gradual pickup would not be enough to bring down the unemployment rate quickly. At the end of 2014, the researchers expect the rate to still be about 1.5 percentage points above "full" employment, which is thought to be roughly around 5.5%, plus or minus. (Full employment is historically around 5%, and economists are currently debating what "full" employment is right now, given structural unemployment that may limit how low unemployment can go before inflation becomes a problem. This acknowledges that some parts of the labor market will be tight even while other workers won't find work.)

The San Francisco Fed researchers note a number of positives in the economy. The housing market shows signs that point to recovery, and consumer optimism is consistent with both an improved perception of the labor market and, by extension, improved consumer spending over time. Inflation is expected to be tame, though food and energy may bounce around a bit.

The caveat, though, is that business investment has been restrained. Just as I might be cautious as a portfolio manager about putting all my dollars on one outcome (cliff or no cliff), businesses are also cautious. While they may be hiring more than they have been, they too are refraining from investing all of their available funds until the outcome becomes less bifurcated among two very different scenarios and becomes more knowable.

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