The US election is finally over and President Obama has been re-elected for another four-year term in the White House. That doesn’t mean an end to the political uncertainty however, with the fiscal cliff now firmly in the minds of investors.
In today’s article we will explore the origins of the fiscal cliff, why it truly represents a nightmare scenario for US economy and whether Obama and Congress will succeed in resolving it.
The origin of the cliff
The fiscal cliff describes a scenario where the US economy, because of US$600 billion in legislated spending cuts and tax increases, plummets into another recession.
Why the term ‘fiscal cliff’? A way to understand this is to picture a driver (US lawmakers) steering their car (economy) over a cliff, either inadvertently or intentionally depending on your point of view.
To be more precise the fiscal cliff involves a combination of the following changes coming into effect simultaneously on 1 January, 2013:
- – Expiration of tax cuts passed during the early years of the George W. Bush Presidency, worth US$280 billion
- – Expiration of temporary payroll tax cuts passed in 2010, worth US$120 billion
- – Roughly US$40 billion in tax increases related to 2010’s health care overhaul
- – US$108 billion in across-the-board spending cuts passed by Congress as part of 2011’s debt ceiling negotiations
- – US$52 billion in other spending cuts
The fiscal cliff was largely borne out of last year’s debt ceiling negotiations. If we recall, US lawmakers were locked in a heated debate over whether to raise the debt ceiling (similar to increasing a credit card borrowing limit).
A failure to raise the ceiling would have led the US to default on its debt, potentially triggering a financial crisis. Lawmakers agreed to raise the ceiling, but to deal with the nation’s huge debt, they also agreed to implement a series of spending cuts.
Whether the timing was intentional or not, the cuts would coincide with other tax cuts already slated to expire. Lawmakers believed the threat of recession would force them to come up with a more comprehensive deal to reduce US debt before 2013. We have now arrived at that point.
Driving over the cliff
Given the fragile nature of the US recovery, it is apparent the economy will not be able to withstand the shock from all these changes. Estimates of the damage to the economy include a 6% contraction in GDP, and a surge in the unemployment rate back above 10%.
One needs only to look at Europe to witness the economic destruction that can come from poorly thought out tax hikes and spending cuts.
Greece is still wrestling with a debt crisis despite having passed numerous austerity measures and received two bailouts. Spain’s efforts to cut its debt are also dealing horrible damage to its economy – unemployment there has surged to 25%.
Given America’s importance to the global economy, a failure to resolve the fiscal cliff would likely lead to a severe worldwide slowdown that would reach Australian shores.
It seems the markets are already pricing in the possibility of Obama and US lawmakers failing to agree on a resolution. Wall Street suffered a calamitous decline just after the election, with the major US indices sliding at least 2% each.
We fear there will be more losses like these to come unless Congress makes meaningful progress on the fiscal cliff.
Avoiding the cliff
The big question is how and even whether the fiscal cliff will be averted. The how is deceptively simple; enough Republican and Democratic politicians agree on a law to eliminate or at least postpone the cliff.
Given the brutal fights between these two parties over the past two years however, no agreement will be reached unless it is accompanied by intense disagreements and political point scoring.
At best, we are likely to see politicians authorise legislation that will postpone the fiscal cliff until sometime next year. How likely is this admittedly less-than-ideal scenario? Well, if last year’s debt ceiling negotiations is anything to go by, then not very likely.
However, given the seriousness of the damage likely to be dealt to the US economy, we think there is an 80% chance the fiscal cliff will be at least be postponed past January.
Postponing Armageddon will hopefully offer enough time for Congress to pass a more comprehensive debt reduction solution.
Any debt reduction legislation must ultimately entail a combination of tax and entitlement reform, as well as policies designed to stimulate growth – after all, higher growth = higher employment and company profits = higher tax revenue = more money to pay down debt.
This is the end goal that must be achieved in order to put the US economy on a path to lasting growth.
Putting things into perspective
We have included this graphic to show you just how much debt the US has accumulated. This includes not only government debt, but private sector debt and all unfunded liabilities.
The tallest ‘building’ in the picture is a stack of 100 dollar bills which, as we can see, is almost double the height of the twin towers.
The amount I hear you ask? $114.5 trillion!