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Going over the fiscal cliff would hit the fragile U.S. economy with about $800 billion of tax increases (mostly) and spending cuts in calendar 2013, or about 5% of GDP. Now there’s not much history of this sort of thing in the United States, but there is some. Citigroup:
There is nothing in the recent history of U.S. fiscal policymaking that matches a policy shock on this scale. Leaving aside the policy missteps of the 1930s, the only comparable experience with major fiscal tightening in the postwar era occurred in 1968 in a radically different economic and financial environment.
An across-the-board 10% surcharge in income and corporate taxes (along with other tax hikes and selective spending cuts) was imposed to pay for the Vietnam war buildup but also as a major countercyclical move to halt an inflationary boom. That tightening amounted to 3% of potential GDP in fiscal 1969 (which ran from July to June in that era) and an additional half percentage point in 1970.
That tightening in fiscal policy was instrumental in slowing GDP from an overheating 5% pace to 2% in mid-1969, by which time monetary policy was tightening significantly, aided by the effects of disintermediation on the supply of money and credit. By the end of 1969, the economy entered a mild recession that continued through the end of 1970 when a very damaging auto strike lasting more than two months slowed manufacturing activity sharply in the fourth quarter. As a result, it is hard to isolate the full effects of fiscal restraint from other events. Nonetheless, signs of slowing appeared abruptly with the passage of the tax surcharge, a few quarters before financial conditions tightened severely in the spring of 1969.
Shorter, the fiscal tightening led to a recession. As show in the chart below:
And keep in mind the U.S. economy was far more robust heading into the 1966-67 downturn than it would be right now. Then it was growing around 5% a year. Today? Barely 2%.
The downturn was also an important milestone in what turned to be a long-period of economic decline for the United States. That’s reflected in the stock market’s horrible performance from 1966 through 1982. It basically when nowhere in nominal terms, as seen in the chart below from Yahoo Finance of the S&P 500:
And adjusted for inflation, stocks fell by two-thirds of that period. It was a period marked by rising taxes, regulation, and easy money.
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