CBO: Fiscal Cliff Effects Now Look Worse

The cliff could mean negative growth next year, but the economy looks weak either way.

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The fiscal cliff suddenly looks a little bit scarier.

The Congressional Budget Office released new estimates Wednesday of the potential outcomes of the "fiscal cliff" at the end of 2012, and the picture looks bleaker than it did earlier this year.

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Nearly $500 billion in fiscal changes are set to go into effect at the end of this year, including scheduled spending cuts and the end of Bush-era tax cuts. If all of those changes go into effect, the CBO now predicts it would "lead to economic conditions in 2013 that will probably be considered a recession."

The latest report predicts negative GDP growth in 2013, with the economy contracting by -0.5 percent. That's a significant downgrade from the CBO's May projection, which put 2013 GDP at 0.5 percent, and also from the January projection of 1.1 percent growth next year. The CBO now also predicts that the fiscal cliff would help to bring about a jobless rate of 9.1 percent in the fourth quarter of 2013.

Answering exactly what to do about that cliff is going to be a top priority for lawmakers before the year is out.

"How we're going to get from current law to a smaller fiscal cliff is an interesting question," says Joel Prakken, chairman of Macroeconomic Advisers, a St. Louis-based economic analysis firm. "I'm not sure either party can really afford to have a fiscal hammer blow dealt to the economy at the end of the year."

All of which is not to say that the economy would be rosy without the fiscal cliff. If Congress averts the tax hikes and spending cuts, GDP is estimated to grow at only around a 1.7 percent next year, with the unemployment rate in the fourth quarter estimated to still be at 8.0 percent.

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The steep drop-off is not without its potential benefits. Under an alternative scenario in which the cliff does not come to pass, the 2013 deficit would be $1 trillion, compared to $641 billion with the cliff. Ultimately, the cliff could lead to federal debt-to-GDP ratio of 58 percent in 2022, compared to 90 percent without the cliff.

While that kind of deficit reduction would in the long run boost the economy, says Prakken, those long-term benefits would only come after the pain of slow growth and elevated unemployment.

"I think that's a legitimate policy issue: how quickly do you want to do this, particularly if the economy's weak to being with, and the Fed can't respond to the additional weakness by lowering interest rates anymore?" he says.

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As for the immediately near-term, CBO estimates have improved slightly. In January, the agency predicted an average 2012 unemployment rate of 8.8, a figure it now puts at 8.2 percent. Likewise, It has shifted its 2012 annual GDP growth projection up slightly, from its 2.0 percent in January to 2.1 percent now.

Danielle Kurtzleben is a business and economics reporter for U.S. News & World Report. Connect with her on Twitter at @titonka or via E-mail at dkurtzleben@usnews.com.