Fiscal Cliff

US on edge of fiscal cliff

The US faces huge spending cuts and tax increases if it fails to tackle its debt problem, but the market believes a deal will be reached

PUBLISHED : Wednesday, 14 November, 2012, 12:00am
UPDATED : Wednesday, 14 November, 2012, 3:20am

After spending a record US$6 billion on the most bitter election campaign, politicians in the United States have resumed their headlong rush towards the fiscal cliff. Both newly re-elected President Barack Obama and House Speaker John Boehner have made conciliatory noises without actually making any bankable concessions.

Punters on the New York stock market made their clear bets: there was no celebration and the market had its worst two-day fall in a year.

Most watchers of the three-ring political circus - White House, House of Representatives and Senate - believe that the politicians will reach a compromise just before the brink.

But if it is merely a fudge, not a stepping stone to a real and lasting solution, it would just send a wretched message - that the US is not capable of conducting its economic policy in a grown-up way, and it will hasten the end of the era of American imperium.

Obama is sticking to his guns that the rich must pay higher taxes in any deal to sort out the fiscal mess; Boehner repeated the Republican pledge not to raise tax rates.

In some ways this is a matter of semantics since one leading issue is the disastrous tax cuts of former president George W. Bush, which are due to expire. When they do, can this really be called a tax increase or just a resumption of normal rates?

At the heart there are deep differences in philosophy. The Republican heartland is steeped in Protestant traditions of the old settlers, suspicious of the role of government. Modern Democrats, many descendants of more recent migrants to the country, believe that the state has an important supportive role to play, especially in hard times and in protecting the vulnerable.

On top of this is the highly combustible mix of politics and economics, which can so easily be sparked by personality or personal ambition, of which there is plenty flying around after Obama's re-election.

The US faces a problem beyond the fiscal cliff. Next year, it will also run against the ceiling on its borrowings, which now stand at US$16.4 trillion, so a comprehensive debt deal needs to deal with this as well as the immediate issue of the budget deficit.

The clock is ticking. Unless the politicians can reach a deal, on January 2, deep and dangerous spending cuts and tax increases will automatically take effect. The Bush tax cuts, the temporary payroll tax reduction and the extension of jobless benefits will all lapse, payments to doctors under Medicare will be reduced, and about US$1 trillion of defence and discretionary spending will be cut over the next 10 years.

Between US$600 billion and 720 billion will be wiped from the economy next year, sending the US back into recession.

The Congressional Budget Office forecasts that if the US falls off the fiscal cliff, gross domestic product will shrink 0.5 per cent, instead of growing 1.7 per cent, and unemployment will rise to 9.1 per cent. Some economists believe that the actual outcome would be worse, with unemployment topping 10 per cent. The Tax Policy Centre estimates that taxes on average middle-income households would rise almost US$2,000.

Then the politics begins to work, or not. No one wants the grim scenario, but in this dangerous game of chicken, the trick is not to be the one caught or blamed for triggering the weapon.

The rating agencies are pessimistic, with Moody's threatening a further downgrade if the US does not adopt fiscal austerity, a threat that has economists such as Randall Wray spluttering that the raters are "clueless". "The same raters who happily gave AAA ratings to the trashiest mortgages the world had ever seen warn about rising default risk of a sovereign currency issuing government," he said.

There are three options:

  • The president and congress may get together and strike an all-embracing bargain that will solve the issue;
  • They will reach some kind of compromise under which they will postpone the real fight - or negotiations - until next year and will, meanwhile, push back all or parts of the fiscal cliff until next year;
  • They will fail to reach any compromise and trigger the cuts.

All the scenarios have difficulties. The idea of a complete solution before the January deadline would require a lot of hard work. Erskine Bowles, widely tipped to take over from Timothy Geithner as the treasury secretary, argues that now is the best time with Obama fresh from his triumph of re-election.

However attractive that notion may be, the Congress is heading into a short and "lame-duck" session where all members of the House have come to the end of their terms, as do a third of the senators.