Will the Fiscal Cliff cause a deep recession in 2013?

Nobody really knows exactly what the impact on the U.S. economy will be when the U.S. government hits the so-called "Fiscal Cliff" at the start of 2013. For sure, there will be SOME significant impact, but I do not concur with the common assumption/belief that there will necessarily be a deep recession. Even ignoring the prospect that there might be some compromise agreement to blunt the full cliff (expiration of tax cuts and automatic government spending cuts), there is simply no way to predict how the "sequester" will actually play out and exactly how government vendors will respond, and not all workers will respond in the same way as their taxes rise modestly.

 

We also don't know how the Federal Reserve will respond, but it is safe to say that the Fed would respond dramatically if the negative impact of the cliff is in itself too dramatic.

 

To put it simply, there are too many wildcards to predict the precise outcome.

 

I would say that there is a 50/50 chance that we will hit the full cliff without any compromise agreement. But even if we do initially hit the full cliff, I strongly suspect that there may be a follow-up partial compromise agreement if it appears that the actual impact of the cliff is too severe. So, maybe the full impact for a prolonged period might be only a 1 in 3 or 1 in 4 probability event.

 

I strongly suspect that the private sector will pick up a large portion of any shortfall in government services. One reason is that providing services to the federal government is very appealing and profitable business if you can get it, and in that sense a lot of government business is a diversion of productive capital away from the private sector to the public sector. So, if the potential return on capital from the public sector dwindles in any real way, private capital will tend to shift to other places where it can be deployed more productively. So, a drop in government business could result in a rise in private sector business. Or maybe not, but the prospect is still there.

 

The bottom line is that I personally expect that although the first three quarters of 2013 will be relatively weak, they still will NOT amount to a deep and long recession. At least two of those three quarters will be quite weak, and maybe one, two, or three of them may be negative, but the sum of all three will have only a 50/50 chance of being negative.

 

I predict that a year from now we will be patting ourselves on the back for "dodging the bullet." The naysayers will of course insist that "it could have been worse, much worse." Indeed, but in my book reality trumps what could have been.

-- Jack Krupansky