Obama talks 'fiscal cliff.' Why the urgency to reach deal sooner, not later?

Members of Congress have wasted no time laying down markers on how to deal with the so-called “fiscal cliff.” About midday Friday, President Obama will take his turn. Why the urgency?

In part, it’s obvious: The fiscal cliff is a large collection of tax cuts that expire on Dec. 31, coupled with automatic reductions in federal spending that are scheduled to take effect. If taxes go up and government suddenly curtails its spending by $109 billion, all set to happen just seven weeks from now, the US economy is expected to take a fall, whacked by a big hit to consumer spending activity.

Politics is another factor. Now that the election is over, lawmakers and the president are jockeying to set the agenda for the hard bargaining to come.  

Those are the basic reasons. But here’s an important piece of the economics behind the cliff: When a deal gets done may be just as important as what deal gets done.

If the dealmaking process takes too long, the impact of the fiscal cliff on the nation's economic growth will be much larger, economists at Bank of America Merrill Lynch wrote in an October analysis. "The decision process will matter as well as the outcome," they conclude. 

The economists looked at various scenarios for how to deal with the cliff. Going across their grid were three options for what lawmakers might do – resulting in either a small, medium, or large cliff that the economy falls over. Reaching a deal that leaves only a "small" cliff could allow the economy to post decent growth. Doing less to address the cliff – allowing some tax hikes and spending cuts to occur – would weaken the pace of growth. (In all three scenarios, Congress would do something, not nothing, about the cliff.)

But here's where the timing issue enters in.

The economists also considered three scenarios for the bargaining process in Washington: one in which a fix is fully crafted and takes effect on Jan. 1, one in which Congress takes a multistage approach (delaying most of the cliff for a few months and then crafting a permanent deal in the new year), or a retroactive fix, in which the economy goes fully over the cliff in January, and then Congress attempts to reverse many of the effects after the fact.

In the analysis by Bank of America Merrill Lynch, led by economist Ethan Harris, delay proves costly to the economy. Regardless of the cliff's size (the small, medium, or large scenarios), economic growth could be negative during the first half of next year if Congress deals with the issue retroactively.

"At one extreme, if the whole cliff is resolved before year-end and the [spending] cuts are modest, the economy survives largely unscathed," growing at a 2.5 percent pace in the first half of 2013, Mr. Harris and his team write. "At the other extreme, going over the Cliff for two months ... results in a mild recession," even if a medium-size effort to reduce the cliff is enacted retroactively.

Taking no action at all would be even worse, many economists say. The Congressional Budget Office has estimated that unemployment would jump to 9.1 percent next year in that case.

The coming changes to fiscal policy can affect the economy in a few important ways.

First, even before the cliff arrives there's an uncertainty factor that can delay things like business hiring, investment, and even consumer spending. So far, it appears that a potential end of Bush-era tax rates has not caused consumers to adjust their behavior much. But that could change if going "over the cliff" starts to appear likely. Businesses may have already started adjusting their behavior, wary of a slowdown in the economy in the new year.

Second, to the degree that tax hikes and federal spending cuts do occur, that has direct impact on behavior. US households will have less spending power, and reductions in federal outlays for things like defense and transportation will also mean sizable job losses.

Both Democrats and Republicans say it's important not to let the economy slide back into recession, but both sides also feel pressure to put federal budgets on a more sustainable path for the long term. Otherwise, the national debt could grow to a scale that damages the economy.

And both sides are pushing to have any deal done their way: Republicans guarding against tax hikes and Democrats calling for more tax revenue from the top 2 percent of taxpayers.

In that environment, uncertainty abounds about the shape of a deal – and the timing of a deal. In an interview published Friday by USAToday, House Speaker John Boehner (R) said Congress should put in place a deal to delay much of the cliff, by extending tax cuts for another year. He argued that it should be the newly elected Congress next year, not the lame-duck session that occurs during the next few weeks, that should decide such important tax and spending matters for the long term.