US plays chicken on edge of fiscal cliff

Chicken is not a complicated game. Only one thing can improve your chances of winning: sending a credible signal that you will not be the person to swerve from the collision.

Election over, the Republicans and Democrats are now revving up for the fiscal cliff, and the game is chicken. If there is no deal then everybody loses; if one side swerves then the other wins; and if both swerve – extending all current policy – then we come back next year and do it all again.

In order to show that they will not swerve, politicians on both sides are publicly flirting with the idea of going over the cliff, at least temporarily.

If everybody knows how much damage this would do then the credibility of these threats is easy to assess. The danger comes, however, if people have different views of the cost, making their actions less predictable – and so far economists have not helped by sending out a mixed message.

The fiscal cliff refers to a range of tax rises and spending cuts that are due to come into effect at the end of the year, including an end to income tax cuts passed by former president George W. Bush, that in total amount to about 4 per cent of gross domestic product.

The Congressional Budget Office puts the full cost of going over the cliff at almost 3 percentage points of output and 3.4m jobs by the end of 2013. That would mean a recession. This is the scary message.

Those figures, however, describe the cost of going over the fiscal cliff and staying there for a whole year. If Congress did a deal early in 2013 then only part of the effect would be felt – for example, the Treasury might be able to keep withholding tax from pay cheques at the 2012 rate.

Going off the cliff for a couple of weeks might mean a loss of as little as 0.1 per cent of output, prompting flogging the thesaurus in a search for cliff synonyms that are closer to a nursery slope than the black run at Verbier. This is the less scary message.

Gavyn Davies

Anatomy of the US fiscal cliff

Serious economic policy makers in Washington, however, consider it foolish to think that the US can go off the fiscal cliff and then painlessly climb back up.

The issue is not the percentage of spending taken out of the economy; it is the blow to confidence. Going off the cliff would be an emphatic indication that an election had done nothing to make Congress more willing to compromise.

Businesses and consumers would have to price in more years of dysfunctional government. Credit rating agencies consider the effectiveness of fiscal institutions, so even though going off the cliff would lead to higher revenues and lower spending, it might prompt a downgrade.

Going off the fiscal cliff would mean that the limit on US federal borrowing would not be raised, as it must be by about March. While fiscal tightening may take effect over time, the debt limit is hard and immediate. If it is not raised then the US would be in danger of default.

The last brush with the debt limit, in 2011 shows the harm that would be done. That fiasco caused a marked slowdown in business investment and sapped momentum from the recovery. The debt limit was eventually raised in time; the argument over it, however, still caused huge economic damage.

Markets would also react immediately, most likely even before the US goes off the cliff, and often overshoot. A big fall in stock prices would cause a further fall in confidence – quite aside from the direct effect of lower wealth on consumption – and that in turn could cause a further drop in stock prices.

Finally, consider what would happen if the US public held its nerve and kept hiring and spending, full of belief that Congress would sort the situation out in January. If there were such a sanguine response then all the pressure to do a deal would disappear – in which case that response would no longer be justified.

The cost of a collision in this game of chicken is high. As long as the politicians realise this, the chances are that one side or other will swerve and a deal will be made.