Michael Collins, Investment Commentator at Fidelity Worldwide Investment, writes about the fiscal cliff; the $600bn combination of spending cuts and tax increases that could tip the US into recession unless something changes between now and January 2013.
In the US, the expiring 112th Congress will hold power until the new one is sworn in on January 3, following November’s election. Through the scheduled sitting days in October, this Congress approaches what is generally derided as its lame duck session. But not this time.
The outgoing Republican-controlled House of Representatives and the Democrat-controlled Senate are bound to negotiate overturning the tax increases and spending cuts that take effect from January 1, which will remove about 4% of spending from the US economy. The blow to the economy is so drastic it is envisaged as the US economy falling off a fiscal cliff.
Lawmakers may fail to untangle the political fix they reached in August last year to end the crisis over raising the federal government’s debt limit. The US economy would then be hit with the same austerity poison that has plunged Europe into recession. Better outcomes are possible. There is, however, one that is far worse than the US diving into a recession, as troublesome as that would be.
The state of Washington’s finances is feeble as the country heads for the fiscal cliff. The US federal government ran a deficit of US$1.1 trillion (A$1.1 trillion) in fiscal 2012, which equates to about 7% of GDP. Federal debt held by the public has soared to US$11.3 trillion, which equals
73% of GDP, the highest level since just after World War II. At the same time, the US economy is spluttering at a sub-2% pace of growth and unemployment is just under 8%. The ideal solution would be for US lawmakers to agree to a long-term plan to fix US government finances. This would include tax increases and spending cuts, while maintaining some short-term stimulus to prod the economy.
Tax- and stimulus-hating Republicans are largely to blame for preventing a grand solution for US government finances. Much of their venom was stirred when President Barack Obama pursued healthcare reforms in his first two years in office for they spawned the Tea Party Republicans who are polarising the political process.
The details of the fiscal cliff are that, unless both houses agree to do otherwise, provisions in the Tax Relief, Unemployment Insurance Reauthorisation and Job Creation Act of 2010 will expire. On the tax side, income-tax cuts first enacted by George W. Bush, the extension of emergency jobless benefits and a two-percentage-point reduction in payroll tax for social security will end. Taxes on capital gains, dividends and estates will jump. On the spending side, the biggest hit will come from the automatic spending cuts tied to the Budget Control Act of 2011.
The government Congressional Budget Office estimates that these tax increases and spending cuts will lop nearly US$500 billion from Washington’s deficit in 2012 to reduce it to US$641 billion in fiscal 2013. “Such fiscal tightening will lead to economic conditions in 2013 that will
probably be considered a recession,” the Office says in a massive understatement.
The better options
In a sense, then, the default option is that there are no changes to any of the laws, the federal budget deficit narrows and the US economy slumps into a recession. Moody’s said in September that such an outcome, “which could lead to instability”, would prompt it to remove its triple-A rating from US debt, as Standard & Poor’s did in August last year. Assuming no comprehensive solution is found in coming weeks, there are three
other broad outcomes from the tangle the US political class finds itself in.
Two are better short-term solutions than a recession caused by a US$500 billion drop in government stimulus, while one would be far worse.
While no one wants to encourage politicians to dither, perhaps the best result for the US is that the outgoing Congress passes onto the 113th Congress the task of finding a substantial solution to the Washington’s financial woes. It can do this by extending all the expiring tax cuts and postponing any spending increases for, say, six months. Therefore, the US economy will stumble along into the New Year, though government deficit and debt numbers will worsen too. The new Congress can squabble about federal finances while raising the debt limit again by March.
The next best result would be some sort of compromise by the expiring Congress. The interesting thing about the Republican-driven political fix that led to the fiscal cliff is that the spending cuts were designed to be unpopular with voters. The thinking was that this would prompt rational compromises by both sides to evade a government-induced recession. It’s likely a deal will be struck to avoid many of the spending cuts, such as those on the military, and that other unpopular steps such as income-tax increases on the middle and working classes will be skirted.
The party that gets the biggest electoral boost from the elections in November will have the upper hand in shaping any compromise, though no party is likely to end up with the presidency and effective control of both houses. (It takes 60 votes to prevent filibusters in the 100-strong senate, even if 51 votes gets budget bills passed.) But it is likely that any such pact will still amount to a sizeable contraction in government spending. Even though the US housing market is improving, the energy industry is undergoing a shale-driven revolution, the banking system is sounder, lower wages make US companies more competitive and consumers have paid off much debt, the feeble US economy may not be strong enough to cope with even a small fiscal contraction, even one that amounted to just 1% of GDP.
What would be worse than lawmakers removing government spending worth up to 4% of GDP from the economy and plunging the US into recession? The answer is that the likely brinkmanship and ill will involved in talks on the fiscal cliff rattle investor faith in the US political system to such an extent that they become reluctant to hold more US debt.
Recall the dysfunction on Capitol Hill in mid-2010 when politicians in Washington took the US government close to default as they renegotiated the federal government’s debt limit. Republicans refused to compromise on the pledge nearly all have taken to never agree to net tax increases. Instead, they suggested spending cuts that would upend about 70 years worth of progress on social security. The standoff with Democrats, who call for higher taxes on the rich and want to protect social-security programs for the needy, prompted S&P to downgrade the US government’s credit rating from triple-A. The rating agency’s verdict – that crazed politics leads to dysfunctional finances – failed to fluster investors in US bonds last year because US Treasuries were – and still are – a haven from the eurozone’s possible implosion.
That sanctuary status might vanish if in the last days of 2012 US politicians miscalculate the tolerance that investors have for the US being held to ransom by lawmakers posturing about pseudo-ideologies. The world economy could probably survive Greece quitting the euro, a slump in China or even a confrontation in the Middle East sparked by an Israeli attack on Iran. It will struggle, though, to combat a collapse of faith in US government debt due to irrational brinkmanship on the fiscal cliff wrought by anti-government and anti-tax fanatics. The US and global financial systems would be vulnerable because they are based on the premise that US debt is a riskless asset. The US and world economies will be devastated if US bond yields, the benchmark for global yields, soar. The political backlash against those responsible will be huge. Investors can be confident that not even lame ducks are that dumb.
Note: US government financial figures come from the Congressional Budget Office. Other financial information comes from Bloomberg unless stated otherwise.