The US’s Congressional Budget Office (CBO) forecasts that the US fiscal deficit will hit $1.1 trillion this year - or 7.3 percent of GDP. But for 2013, the CBO projects the deficit falling to $641 billion, or 4 percent of GDP.
The CBO forecast for 2013 incorporates the improvement related to the so called “fiscal cliff”, which refers to the enormous amount of automatic tax hikes and spending cuts set to take effect starting in 2013. This includes the expiration of the Bush tax cuts and the enactment of $1 trillion in other across-the-board spending cuts that will be automatically triggered if the US Congress fails to come up with an alternative debt-reduction plan.
Even though the enactment of the “fiscal cliff” would greatly reduce the US deficit and improve debt sustainability and, by implication, the country’s long(er) term growth prospects, such a sharp drop in demand within a year will jeopardize the already weak US and global recovery.
In fact, the weak global recovery of 1Q2012 gave way to a synchronized slowdown in Q2, as financial market stress in the Euro area periphery intensified. Although financial markets have stabilized and improved over the last few weeks, real-side data (which lag financial market data) remain weak and, so far, do not suggest that a significant pick-up in activity is underway. At best, we can hope for a moderate recovery by year-end.
But such a recovery will be negated and reversed under a full blown “fiscal cliff” scenario, as the deficit reduction would represent the largest single-year drop in the annual fiscal deficit as a share of GDP since 1969. Over the short(er) term, this will have very significant aggregate demand and growth implications for the US as well as the rest of the world.
Already the World Bank’s preliminary baseline forecast suggests that events-to-date imply a downward adjustment to the Global Economic Prospects June 2012 forecasts.1 Global growth is now expected at around 2.3 percent this year, and 2.6 percent in 2013 (a 0.2 and 0.4 percentage point respective downward revision since June). This latest baseline forecast incorporates US growth of 2.3 percent and 2.0 percent in 2012 and 2013 respectively, and is built on the assumption that about 70 percent of the imminent “fiscal cliff” will not expire.
But what would happen to US and global growth in an alternative scenario where the full-blown “fiscal cliff” becomes effective during 2013? Simulations on the World Bank’s macroeconomic model indicate that the impact of the tax hikes and spending cuts, combined with the lower fixed investment spending in response to lower demand, which is to some extent offset by falling US imports, is likely to result in a 2.2 percent decline in US output in 2013, when compared to the baseline.2 Given the current baseline US growth forecast of 2 percent in 2013, an abrupt unraveling of the US “fiscal cliff” may push the US back into recession again. Albeit significantly costly in terms of US output forgone over the short(er) term, significant progress will be made in terms of reigning in the US fiscal balance, which is forecast to decline to around 4 percent (of GDP) in 2013, and to around 3 percent and 2 percent (of GDP) in 2014 and 2015 respectively.
With US output declining, the rest of the world is primarily affected via two transmission channels. Firstly, other countries (predominantly high-income and mainly European) are affected through reduced exports as US import volumes fall by more than 5 percent. Overall, global trade volumes are projected to decline by around 1½ percent (relative to baseline). Secondly, the weaker global growth contributes to a 6 percent decline in oil prices and a 2 and 1 percent drop in metal and internationally-traded food commodity prices.
Also in the Euro Area where the baseline forecast is for a very weak growth recovery of only 0.3 percent in 2013, an adverse unraveling of the US “fiscal cliff” will also push the Euro Area back into recession with output in the Euro Area expected to decline by 0.4 percentage points relative to the baseline. For high-income countries as a whole, GDP is forecast to decline by just more than 1 percent when compared to the baseline. Among high-income countries the trade-channel impact dominates and the slightly lower commodity prices only marginally soften the overall negative impact.
Even in developing countries the impact is not negligible, at 0.6 percentage points in aggregate. And the impact will be widespread, with 38 developing countries experiencing a GDP decline of half a percent or more, while for 18 developing countries, the deterioration in the fiscal balance will be at least ½ percent of GDP.3
Declining global demand for oil and the resultant downward pressure on prices is forecast to reduce domestic income and (oil) tax revenues, with GDP and fiscal balances falling by 0.7 and 2.2 percent (of GDP) among developing oil exporters. But also in commodity exporting countries such as South Africa (-0.3 percent), Argentina (-0.4 percent) and Chile (-0.5 percent), GDP is forecast to come under significant strain. Moreover, fiscal and current account balances are forecast to deteriorate by around 0.3 and 0.5 percent of GDP in these three countries.
The hardest hit developing countries will be those that are relatively open. Thus, the East Asia and Pacific region, with its strong global trade linkages, is particularly vulnerable, with output in the region forecast to decline by 0.8 percent, when compared to the baseline. In addition, countries such as Mexico, where exports to the US represent a large share of the export basket, are also vulnerable to a slowdown. Simulations suggest that Mexican exports and GDP is forecast to decline by 4.9 and 1.4 percent respectively, while the Mexican fiscal balance is forecast to deteriorate by 0.4 percent of GDP.
At first sight, it would appear that there might be few spill-over effects to low-income countries, with a projected GDP decline of only 0.1 percent – reflective of their weaker global trade integration and benefits being accrued somewhat from lower oil and food prices. But for many low-income commodity exporting countries, lower commodity prices also mean lower incomes and tax revenues. In fact, among developing country regions, the deterioration in fiscal balances will be most severe in Sub-Saharan Africa, with a projected decline of 0.9 percent of GDP. Moreover, low-income countries are particularly vulnerable as the deterioration in GDP and fiscal balances in high-income donor countries may negatively impact aid flows (not taken into account in the above simulations).
1. Irina Magyer provided modeling and programming assistance.
2. These are very preliminary results (work in progress) and the underlying assumptions, technical equations and outcomes remain subject to (significant) revision.
3. In the macro model used to do these simulations, we have included 80 developing countries for which sufficient data exists.