Published On: Mon, Sep 10th, 2012

How Much Risk does the US ‘Fiscal Cliff’ Pose to the World Economy?

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In her speech to the Asia-Pacific Economic Cooperation (APEC) summit in Russia this week Christine Lagarde, the head of the International Monetary Fund (IMF), described the ‘fiscal cliff’ facing the US economy in 2013 as one of the biggest risks to the global economy, alongside the Euro crisis and the sovereign debt crisis. So I decided that now would be the right time for an in-depth WNC report on the fiscal cliff, the potential risks it poses to the American economy and the broader global economy, and the most likely outcome according to the experts.

What Is The Fiscal Cliff?

At the start of 2013 a wide range of tax increases and government spending cuts are all set to take effect at the same time, potentially taking a massive amount of money out of the US economy overnight and pushing the country off a metaphorical ‘fiscal cliff’. Bush era tax cuts, the payroll tax cut, and other important tax-relief  provisions are all set to expire at the end of 2012, and no agreement has been made by the government to extend or replace them, meaning that in effect there would be a substantial increase in the tax burden of the American people if nothing is done to change this situation. This tax increase would coincide with the first installment of $1.2 trillion in planned cuts to both domestic and defense programs, which is required under last year’s bipartisan deficit reduction agreement.

Why Is That Such A Problem – What Is The Worst That Could Happen?

The main danger of the fiscal cliff is that such a large amount of money being pulled out of the US economy would plunge the country into recession – and potentially a deep recession as well. According to Citigroup the results of a full fiscal cliff, i.e the full range of tax increases and spending cuts hitting together, would be a 4% contraction in GDP for the financial year, and close to 5% over the 2013 calender year. UBS has forecast a GDP contraction of 4.7% if this happened.

A 5% contraction in GDP is bad – but that is not even the worst case scenario. In order to find a solution to the fiscal cliff problem congress will have to raise the debt ceiling. The debt ceiling is the maximum amount of debt that the government is legally allowed to hold; currently set at $16.4 billion forecasts suggest that the debt ceiling will be reached by February 2013. Increases in the debt ceiling have always been a source of politically wrangling and are never easy to negotiate. If congress cannot agree on an increase in this limit, which would most likely require a solution to the fiscal cliff problem to be reached first, then the US government could potentially default on its debts. This would send the cost of borrowing soaring as well as damaging confidence in the US economy and potentially in the dollar as a safe haven currency. It is difficult to asses the exact consequences of this, but it certainly wouldn’t be pretty.

Russ Koesterich identifies four reasons why people should be concerned about the fiscal cliff:

  1. The shear size of the figures involved
  2. The fact that the US economy is already in a weak condition, with the recovery faltering
  3. The fiscal drag is set to hit the economy where it’s most vulnerable: disposable income. As fiscal stimulus and transfer payments have begun to expire, income growth has decelerated.
  4. Uncertainty: Even if a last minute solution is found, the uncertainty about what is going to happen may have already had a negative impact on the US economy in the final quarter of 2012.

So Why Is Nothing Being Done About The Fiscal Cliff?

Political gridlock in congress is currently hampering efforts to find a remedy for this situation. With so many American citizens feeling the pinch this is a highly politically sensitive issue, and any solution will also have its downsides. The total US national debt recently hit $16 trillion dollars, a huge amount which sets a significant constraint on the governments ability to continue both tax cuts and spending measures. According to data published by the Congressional Budget Office spending and revenues need to be brought into alignment over the next ‘several years’, or the fiscal drag on the economy will reach the point where it will become a long-term weight on overall growth, resulting in higher interest rates and funding problems for government-issued debt. So simply keeping all of the tax cuts and cancelling the spending cuts is not an option – the government needs to find a way to balance the books (at some point in the future at least).

The results of the upcoming presidential election in November will be the key factor in determining how this issue is resolved, but whoever gets in will not find it easy to get their own way, and there is no guarantee that a solution will be found in time. For now both sides seem hesitant to compromise after already having made so many compromises in 2010 and 2011 which they are no regretting. Zero Hedge writer Tyler Durden writes:

Some Democratic lawmakers have indicated that they regret agreeing to extend the 2001/2003 tax cuts in their entirety in late 2010, and have implied they will oppose the next extension more strongly. Likewise, several Republican lawmakers have recently said that they regret agreeing to the Budget Control Act enacted in August to raise the debt limit.

He goes on to point out that there may even be political incentives to allow the fiscal cliff to hit:

Senator Murray pointed out in her comments earlier this week that one political advantage of letting the tax cuts expire is that it would allow Congress to focus on debating how large of a “tax cut” should be enacted next year, since taxes would have already risen, rather than debating how large of a “tax increase” should be adopted. In a scenario in which Republican Presidential Candidate Mitt Romney were to win the presidential election and Republicans took a small majority in the Senate, Republican lawmakers may be inclined to let current fiscal policies lapse at least temporarily until the election results have taken effect in January.

See below for a table of the upcoming tax increases and spending cuts along with a very brief digest of the current political situation (also from Zero Hedge):

What Risks Does it Pose To The Global Economy?

There is an old saying amongst economists that if the United States of America sneezes then the world catches a cold. Although the growth of countries like China has taken some of the edge of that, it is still true – a deep recession and / or debt crisis in America would have a severe impact on the world economy.

A substantive American recession would push the European economy into an even deeper recession than the one which is already looking likely. If the US defaults on debts, that could also aggravate the European debt crisis. The Chinese economy has already been hit hard by the situation in Europe with growth slowing significantly, but with an American recession and deeper than anticipated recession in Europe this effect would be magnified massively.

With investors fleeing from shares and government bonds commodity prices could skyrocket, adding to inflation. Global growth would be hit severely, raising the spectre of global recession.

What Is The Most Likely Outcome?

The chances that the American government will do nothing at all to remedy this situation is minimal.

“Despite all the headlines lately warning about the pending fiscal cliff, I have yet to meet an investor who doesn’t expect Washington to arrive at a last minute deal later this year to avert the tax hikes and spending cuts set to take effect in January 2013

“And I have to admit that I too believe the most likely scenario is another 11th hour compromise that, at the very least, postpones the bulk of the tax hikes and spending cuts.” says Russ Koesterich

UBS has forecast the chances of the full impacts of the fiscal cliff coming into force at less than 5% – so that is not the real problem. The real problem that people like Christine Lagarde of the IMF are worried about is that there will be only a partial solution, or that the agreed solution will not be sufficient.  UBS forecasts a 50% chance that what will actually happen is something they describe as a ‘fiscal pothole‘, in which some of the tax cuts are allowed to expire but not all of them.

Until the politicians give us some idea what they plan to do we can have no idea how big this fiscal pothole will be, but there is a real danger that it will be big enough to tip the US into negative GDP growth and recession. Plus, of course, there is also the other danger: that the fiscal cliff is avoided, but that the solution continues to push up government debt at unsustainable levels, creating a drag on the economy and a potential future crisis.

About the Author

- Dean Walsh is the owner and editor of World News Curator. He also owns and runs Ourly News and a range of other online publications.

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