The Fiscal Cliff

The Fiscal Cliff 

It’s hard to turn on the news at the moment without someone discussing the U.S Fiscal Cliff and the dire consequences of plunging over it. Will a solution be found in time? Will the Democrats and Republicans continue to lock horns or will sense prevail?

 Much of the coverage is the usual ill informed jawboning by the media looking to fill airtime at a traditionally quiet time of year, however this is an important issue and it is already having an impact on financial markets, so let’s take a closer look.

So what is the Fiscal Cliff?

The history of the Fiscal Cliff goes way back to President Reagan’s time in office. Together with the Congress, his administration and the many since have periodically imposed a time limit on themselves to force them to agree to unpalatable tax increases and spending cuts in order to reduce the country’s Federal Deficit.

 In a nutshell, the current inability to solve the issue is because the Republicans want additional cuts in spending rather than higher taxes for the ‘rich’, whilst President Obama and the Democrats want to cut spending less severely but recoup more in taxes from those earning over US$250000 a year. This is as much an ideological debate as anything else, which explains why they are having such a hard time finding a solution.

The last time this came to a head was in August of 2011 during the Debt Ceiling discussions , and in the best traditions of politicians never to solve anything today that can be put off till tomorrow, they kicked the can down the road until Dec 31^st 2012. After which time, unless an agreement is found, automatic spending cuts and tax increases will be triggered to the tune of US$560 billion, reducing the deficit by roughly half.

 This would have a huge impact with estimates suggesting a loss of 2 million jobs and a 4% fall in GDP in 2013, leading to a severe recession.

Unfortunately there are now a couple of other complicating issues that were not anticipated when the date was set.

Firstly there is the expiration of the Bush tax cuts (tax cuts implemented by President Bush to boost the economy at the time, and subsequently continued by the Obama administration). The expiration of these cuts will act the same as a tax hike, and the fact that they are also scheduled at the same time will only compound the problem.

Secondly, at some point in the first quarter the U.S will once again run up against its Debt Ceiling.

 This is the maximum amount that the government can borrow at any given time, and was set back in August 2011 when both a backstop date of 31^st Dec 2012 was agreed for the triggering of the ‘fiscal cliff’, and an increase of US$2.4 trillion was authorised for the debt ceiling bringing it up to the current level ofUS$16.4 trillion.

This 2011 debate brought the issue into the public eye for the first time, and was a bruising political slugfest, with a deal only being reached at the 11^th hour, and now only sixteen months and US$2.4 trillion later here we are again.

Certainly the repercussions of not getting a deal done are extremely unpleasant. With one of the implications being that the U.S govt would no longer be able to issue more debt to raise funds, it would be unable to meet its financial obligations and the risk of default would increase dramatically.

 We can now see that whilst most people are simply focussed on a resolution to the fiscal cliff, there are a number of issues intertwined, making it a very complex high stakes game indeed. There is a lot to play for and a heck of a lot to lose.

So what do I think will happen?

Well I think there are three potential outcomes:

1.     The politicians on both sides could finally grasp the enormity of what the country faces and putting their ideological dogma to one side agree to a long term plan of eradicating the financial deficit and paying down the country’s debt.

I give this plan about the same chance as Santa coming down my chimney and leaving me the keys to a brand new Ferrari on Christmas Day.

2.     Either the Republicans or the Democrats can see some political advantage in driving the country over the cliff and potentially gaining a better deal once the tax hikes and spending cuts start to bite.

This is a hard one to read but I have absolutely no doubt that either side would do it if they felt they could obtain a clear advantage.

3.     Politicians do what they do best. Grandstand and talk tough long enough to gain approval with their own electorate, and then strike some half-baked deal that solves nothing, kicks the can even further down the road but allows both sides to walk away claiming victory.

Now, call me old fashioned but I know what my money is on.

Of course there is one way they could thrash out a deal very quickly. All they need do is cancel the Christmas holiday for congress, mandate 100% attendance and maintain the session until an agreement is reached. I am sure this would inspire a plague-like outbreak of commonsense and accord.

Unfortunately the likelihood is that politicians will do nothing meaningful until the crisis becomes so severe that the general populace rise up and demand change. At that point they will listen or be voted out, but the chance to solve the problems will have already been lost.

The problems the U.S faces are mammoth, but fortunately for it, there are other regions with more pressing problems. Having been an oasis of calm for a few months now, the Euro zone will burst back onto the scene in 2013 (followed closely by Japan) as the sovereign debt crisis really bites, leading to the U.S temporarily regaining its flight to quality ‘safe haven’ status until it is the last man standing.

It might help to visualise a fleet of ships all sinking at different rates, and as one slips below the waves the crew clamber in hope onto the next one, until that too slips below the waves so they clamber onto the next, and so on until they are on the final ship, and when that finally sinks there is nowhere to go.

That is the global economy, and that’s what awaits us unless we do something now.

I will try to do another post before year end and give an update on how the financial markets are faring, but just in case the call of the beach is too strong I wish you all a fantastic festive season wherever you may be and see you in 2013.