Although we have entered a new year, the same issue that dominated markets in December has maintained its relevance in January. We speak, of course, about the US budget mess that remains largely unresolved despite the year-end agreement to avert the fiscal cliff.
In today’s editorial we will explore more fully the agreement that was hammered out by US lawmakers on January 1.
To remind everyone, the fiscal cliff described a scenario where the US economy, because of a combination of legislated spending cuts and tax increases coming into effect on January 1, 2013, careened into another recession.
For nearly the entire period between the November Presidential election and the end of the year, US politicians struggled to agree on the best way to avert the fiscal cliff. The dysfunction that permeates US politics saw only a modest deal reached by lawmakers.
Just after midnight on New Year’s Day, the Republican Party all but yielded to Obama’s demands that tax rates go up on high income earners as a way to generate greater tax revenue for the government’s coffers.
The deal itself was estimated to bring in US$600 billion in new revenue over the next decade – a not insignificant amount, but still a drop in the ocean compared to the national debt which now exceeds US$16 trillion.
Moreover, US$1.2 trillion in spending cuts that were meant to come into effect on January 1 were merely delayed by two months rather that rescinded completely.
The one good thing to come out of the agreement was that it made permanent tax rates that apply to those earning less than US$400,000 per year. The fiscal cliff would have seen these rates jump, damaging consumer confidence and likely resulting in a significant drop in aggregate spending.
Another component of the fiscal cliff was US$1.2 trillion in across-the-board spending cuts known as sequestration that were borne out of an August 2011 deal to reduce the national debt. The cuts would amount to approximately US$109 billion a year through to 2021.
The cuts were designed to be so bad for the economy that they would force lawmakers to come up with a more comprehensive and less draconian deal, before January 1, to reduce government debt.
However, the sharp polarisation of US politics combined with the utter dysfunction of the nation’s major legislating body, resulted in a failure to reach a comprehensive deal.
Instead, lawmakers scrambled to delay sequestration by just two months. That means on March 1, unless a comprehensive budget deal is reached, there were will be cuts to things like the defence budget as well essential services designed to help those who rely on government aid.
Many are understandably fearful about sequestration. A range of individuals, businesses and organisations are now threatened with a cut in services provided by the government, with the uncertainty likely to result in a cut back on spending, investment and hiring.
The next crisis
The sequestration is but one crisis that awaits the US on March 1. A bigger and far more devastating crisis is also scheduled to occur around that time.
That crisis is a failure to raise the national debt ceiling, which itself is a mechanism that allows the government to increase its borrowing capacity in order to honour previous obligations.
Among these obligations is interest on the debt the US government has racked up, as well as the debt itself. Although we will devote next week’s editorial to the US debt ceiling, we’ll leave you to ponder this: What happens if one cannot pay back their debt? They default.
And what happens if the world’s largest and most important economy defaults? A new financial crisis occurs.