The U.S Fiscal Cliff analysed by Kampamba Shula

The U.S.A Fiscal Cliff

Much has been debated recently in International media as well as in the U.S.A over the fiscal cliff. Democrats and Republicans are at longer heads to get to some amicable deal while the market limbos in uncertainty and businesses hold back on recruitment and capital expenditure.

“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect. Planned tax rises and government spending cuts will create a ‘fiscal cliff’ in the US in 2013 equivalent to 4.7% of national income.

Several fiscal stimulus measures are due to expire at the start of 2013 at the same time as additional tax rises and spending cuts come into force. Should this happen the expected tightening during 2013 would be $655bn, or 4.7% of national income. This is the ‘fiscal cliff’. It dwarfs the planned consolidation in the UK over the same period of 1.3% of GDP. Indeed it is much larger, and more sudden, than planned in bailed out Eurozone countries such as Greece (2.8%) and Ireland (2.6%). Such a sharp and aggressive adjustment in fiscal policy will significantly damage US growth and employment.

• This would lead to a pronounced recession next year. National income would fall by 1.0% and unemployment would rise to over 10%.

• Even partial implementation of these tax and spending changes would severely hamper growth and employment.

• It is imperative that policymakers prevent this outcome. Yet the poisoned political environment makes it difficult to generate the consensus needed to revoke these plans. Looser monetary policy wouldn’t fully offset this fiscal headwind.

• Even if crisis is averted, the long term outlook for the US public finances is a growing concern. Policymakers will have to make tough decisions in order to prevent debt reaching unsustainable levels. This will again require the sort of political consensus that has been sorely lacking over recent years.

Why is the Fiscal Cliff a Big Problem?

The important question to ask is why the fiscal cliff is such a big problem and should the rest of world really be concerned about its implications. Then answer lies twofold, firstly the fiscal cliff is a big problem because it means that the U.S, the world’s largest economy is unable to pay back its debt and secondly when it hits the debt ceiling in February 2013 it will have to default and will not be able to borrow any more, a devastating turn of events.

Why should the world be concerned?

The question that remains unanswered now is what does this have to do with the rest of the world and should they even be bothered. The answer for this question is also twofold; countries like Switzerland, Japan and China would be worried since they own U.S debt while the rest of the world could suffer from a crisis of confidence, and yes we mean crisis. If Stock market indexes in Asia and Europe rally on better housing market data from the U.S what could possibly be the effect of a default on U.S sovereign debt, definitive, the correlation between international markets has deepened due to globalization.

The Real Focus

During an interview with Bloomberg’s Charlie Rose on the Fiscal cliff Warren Buffet said “The world may think we are idiotic, but we are not suicidal.”According to Warren, there is not much to read into the fiscal cliff because he believes a solution will be found that will avert market fears. I tend to agree with Warren but only to certain extent as I do believe there is also a substantial confidence risk that the fiscal cliff poses in the short term.

The real focus of the fiscal cliff discussion is around the tax increases and budget cuts. This seems to be the pin point where Democrats and Republicans seem to be differing in congress. President Obama has proposed a tax increase on high net worth individuals (top 2 %) while rates remain unchanged for the rest of the population. Many say this is a step in the right direction but some CEOs believe it will not be enough; I tend to agree with this view in part.

There is a sacrifice that has to be made. With U.S growing at about 1.5%, for every $1 trillion of budget cuts about half a percentage point will be shaved off GDP, a $4 trillion budget cut is needed.

 Key issues

The incentives to prevent the fiscal cliff from putting the US back into recession are very strong. Even during periods of robust growth such a large and sudden change in fiscal policy would be unwise, but with the US still struggling to recover from the financial crisis it would be a baffling decision. The poisoned political environment, however, makes progress on new legislation difficult. Both the main parties agree that current policies are unsustainable and that deficits need to be reduced. They disagree on how to achieve these objectives. Neither of the competing presidential candidates has offered much by way of specifics, but at a broad level the Republican party continues to advocate spending cuts and reject tax rises while the Democats prefer tax increases and fewer spending cuts. 

To get to the core of this issue it would be appropriate to establish the actual cause of the fiscal cliff, and by this I don’t mean who is to blame between Republicans and Democrats but what policies have led to the U.S incurring such a large sovereign debt. Part of the reason lies in welfare, Medicare and military spending. The problem is neither the republicans nor the democrats are willing to tackle issues of welfare, though the republicans are eager to attack Obama’s healthcare package.

Unfortunately, the fiscal cliff isn't the only problem facing the United States right now. At some point in the first quarter, the country will again hit the "debt ceiling" - the same issue that roiled the markets in the summer of 2011 and prompted the automatic spending cuts that make up a portion of the fiscal cliff.

What do the markets want?

The markets are looking for about a $4 trillion budget cut to ease their fears. The problem is that they probably won’t get that much.

What will the markets get?

In my personal view the markets will probably get some deal from congress which will be something small, maybe in the range of $1.3 trillion (not including the expired Bush tax cuts) and a promise of something bigger later on.

Solutions

 

 

Republicans want to cut spending and avoid raising taxes, while Democrats are looking for a combination of spending cuts and tax increases. Although both parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve. There's a strong possibility that Congress won't act until the eleventh hour. 

Avoiding the fiscal cliff would be positive in the short term, but the US still needs to take decisive action to put its public finances back on a sustainable track. The CBO estimates that the fiscal restraint embodied in current law will reduce the budget deficit markedly to an average of 1.4% of GDP over the 2013-2022 period. Debt as a share of GDP would peak at 76% in 2014 before falling to 61% by 2022. Alternatively, if some but not all of the current tax and spending policies are extended the budget deficit would average 5.3% and public debt as a share of GDP would keep on rising, reaching 93% by 2022 – the US public finances would remain unsustainable. Given this, US authorities need to at some point agree on how to make this medium term fiscal adjustment. The ideal outcome of this issue would be for policymakers to avoid the shock of a fiscal cliff, but commit to long term deficit

Technically, there is a December 31 deadline for Obama and Congress to find a way to avoid hundreds of billions of dollars in tax increases and spending cuts that experts say would give Americans a hangover far worse than what any drunken New Year's Eve celebration could deliver.