The U.S. fiscal cliff could entail significantly more fiscal tightening (by about 3 percent of GDP) than assumed in the WEO projections. A recent Spillover Report (IMF, 2012) finds that if this risk materializes and the sharp fiscal contraction is sustained, the U.S. economy could fall into a full-fledged recession. The global spillovers would be amplified through negative confidence effects, including, for example, a global drop in stock prices. The impact of hitting the debt ceiling is more difficult to model. Political delays before the previous deadline, in summer 2011, led credit rating agencies to downgrade the United States, and major market turmoil ensued. At this stage, markets appear to consider the fiscal cliff a tail risk, given that Congress has in the past eventually reached a compromise to resolve similar high-stakes situations. However, this implies that, should this risk actually materialize, there would be a great shock to confidence that would quickly spill over to financial markets in the rest of the world. Notice that risks for a sudden fiscal withdrawal are also present in Japan: however, if they materialize, they will probably have spillovers that are not as large as those from the U.S. fiscal cliff.
World Economic and Financial Surveys
World Economic Outlook (WEO)
October 2012
Coping with High Debt and Sluggish Growth
by International Monetary Fund
http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf
The U.S. debt ceiling and fiscal cliff
The lessons of the past few years are now clear. Euro area countries can be hit by strong, country-specific, adverse shocks. Weak banks can considerably amplify the adverse effects of such shocks. And, if it looks like the sovereign itself might be in trouble, sovereign-bank interactions can further worsen the outcome.
The budget outlook has also become uncertain in Japan, where a political impasse has delayed approval of budget funding for the remainder of the fiscal year ending in March 2013. Earthquake-related spending has lent support to growth in 2012 but will decline sharply in 2013. As a result, there will be a fiscal withdrawal of about ½ percent of GDP. This withdrawal could be much larger if the political impasse is not resolved soon.
In Japan, the pace of growth will diminish noticeably as post-earthquake reconstruction winds down.