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U.S. ‘Fiscal Cliff’ Looms: Will Lawmakers Heed Bernanke’s Warnings?

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In late February Fed Chairman Ben Bernanke started warning lawmakers about the looming "massive fiscal cliff" that would bring the U.S. economy to its knees if Congress cannot agree on long-term fiscal decisions. Bernanke explained that the confluence of events happening Jan. 1, 2013 - the expiration of the Bush-era tax cuts and extended unemployment benefits, the $1.2 trillion automatic spending reductions and the end of the payroll tax holiday — will likely lead to a recession in the U.S.

Neither political party wants this worst-case scenario to come to fruition but lawmakers are likely to "kick the can down the road" instead of addressing these pressing policy issues before the November elections says Greg Valliere, chief political strategist at Potomac Research Group. Bernanke reiterated his concerns to a select group of lawmakers last week, escalating his rhetoric about the necessity of resolving these budget concerns sooner rather than later.

"I think [Bernanke] is worried, and people at the Fed are worried because this is such a dysfunctional group," says Valliere in the accompanying video. "And there's talk now of a government shutdown on Oct. 1 when the new fiscal year starts."

Bernanke's admonition was not lost on the senators who attended the vis-à-vis encounter. Bernanke probably told lawmakers "you guys got to get your act together because if we do nothing in December…the impact on GDP will be so adverse it will probably lead to a recession," Valliere says.

The economic recovery has proven to be tepid but many in Washington remain convinced the economy will be strong enough to dodge a recession. Recent data suggest otherwise.

The government reported economic growth in the first quarter slowed to 2.2 percent from 3 percent during the last three months of 2011. Employers hired fewer workers in April, adding a mere 115,000 jobs compared to 154,000 in March. Most economists agree that the economy needs to create at least new 200,000 jobs every month for several years to get back to pre-2008 levels. The pro-growth programs that expire at the end of the year could be the setback that triggers another recession. Bernanke verbalized these fears at an April 25 press conference.

"If no action were to be taken by the fiscal authorities, the size of the fiscal cliff is" so large that there's "absolutely no chance that the Federal Reserve would have any ability whatsoever to offset that effect on the economy," Bernanke said.

Economists agree that tax hikes and spending cuts will drag down economic growth in 2013 yet the estimates vary. Moody's Analytics chief economist Mark Zandi predicts the fiscal drag next year could be to closer to 1.5 of a percentage point of GDP. The Congressional Budget Office calculated GDP could drop by nearly 3.6 percentage points in the 2013 fiscal year while Morgan Stanley economist David Greenlaw says fiscal tightening could translate into a 5 percent drag on GDP during the 2013 calendar year.

Valliere doubts Congress will get much accomplished in the 20 lame duck legislative sessions after the election. The "fiscal cliff" will likely be averted in the short term if Congress votes to renew the expiring programs for at least the first quarter next year, as Valliere expects to happen. Until then uncertainty will continue to rattle U.S. markets and put investors and the nation on a very slippery slope.