Composition of the U.S. Fiscal Cliff

Here’s some background and a nice chart on the fiscal cliff prepared by the IMF for last week’s G20 FinMin meeting.  Note also the U.S. debt ceiling, which currently stands at $16.394 trillion with current outstanding debt at $16.245 trillion, is going to have to be raised.

- Current law implies automatic tax increases and spending cuts amounting to $700 billion in 2013—a tightening of around 4 ½ percent of GDP. If realized, this would push the country into a recession with large international spillovers. The severity of the economic effects would partly depend on the duration of the cliff. Even if the ―fiscal cliff were quickly unwound, the damage to the economy could be substantial, especially if consumers and businesses were faced with continued uncertainty about tax and spending policies.

- Moreover, the absence of a deal on raising the debt ceiling also conjures up the specter of a dramatic tightening or even technical default. Failing to do this in a timely fashion adds to risk of financial market volatility. While investors are treating such events as tail risks—as U.S. policymakers have in the past always been able to pull back from the brink—the shocks, if realized, will be very large.

- At the same time, U.S. debt dynamics are not sustainable over the long run. Failing to agree soon on a credible plan to put the federal debt on a sustainable path could exacerbate uncertainty and thereby detract from activity; over the medium to long-term, it could lead to a gradual erosion of the reserve currency status of the U.S. dollar and put upward pressure on Treasury bond yields.

(click here if chart is not observable)

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