The hot item on the financial and economic agenda is ‘the fiscal cliff’. If you haven’t heard about it, you must be living in a wonderful state of disconnection to the news cycle – or perhaps you are a citizen of North Korea. Everyone else is being, and will continue to be bombarded with this phrase virtually non-stop, at least until December 21, probably through year-end, and then again in February-March.
The fiscal cliff, as the name indicates, is to do with fiscal policy, ie taxes and the budget. The cliff bit indicates an abrupt change in the environment, so combining fiscal + cliff gives us an event or phenomenon that is going to cause an abrupt change in the sphere of taxes and the (federal) budget. That event will occur at midnight on December 31, because at that moment several sharp changes will take place in the American tax code. The reason this will happen is because several pieces of legislation defined that date as their expiry point.
Most importantly, the tax cuts initiated by President George W Bush ten years ago will expire then – unless they are extended again. However, President Obama is opposed to these cuts, which are mainly beneficial to the upper income brackets. There are other tax laws, mainly tax benefits and other stimulatory measures initiated in the Obama years, which also carry an expiry date of December 31, 2012. If nothing at all is done, there will be a jump in the tax burden on all Americans, especially rich ones, as well as on corporations on January 1, 2013. In addition, there are also spending cuts that will go into effect – because Congress mandated that this should happen on that day, if nothing had been done by then to cut the burgeoning federal budget deficit.
That, in very simple terms, is the fiscal cliff. In the absence of any action by Congress, the US economy will “go over the cliff” and suffer a sudden contraction, because of the extra taxation and spending cuts. The result will be a recession and the abortion of the gradual recovery that has been underway. That outcome is clearly undesirable, requiring legislators to make every effort to prevent it happening. However, any such effort requires the two Houses of Congress to vote for a new law/s that will avoid the cliff outcome. Since each House is under the control of a different party, that requires the two main parties – and the President – to agree to a single measure or set of measures. But the two parties are incapable of agreeing about taxation and spending – and this is the state of affairs known as ‘gridlock’.
In reality, there is very little drama in this political soap-opera. No-one wants to ‘go over the cliff’, so it won’t happen. However, the lame-duck Congress that will be meeting over the next few weeks, before dispersing on December 21 (hence the importance of that date), is unlikely to agree to substantive measures. The most likely scenario, therefore, is that some stop-gap or temporary solution will be voted for during December, to put the cliff on hold, and then the new Congress will wrestle with the problem when it convenes in January, and eventually – hopefully – a compromise will be hammered out, probably in March. During this period, the markets will continue to be (as they already are) nervous and volatile, reacting to every statement by every senior politician about the prospects of a deal and its contents. Businesses will defer decisions, because the tax rates applying to them, and indeed the wider economic outlook, will remain unclear.
What is most important, however, is to remember that this entire spiel is, at best, a preliminary skirmish – and at worst, shadow boxing. The critical task facing this Administration and this Congress is to adopt a comprehensive and long-term programme for cutting the budget deficit – which is running at an average $100 billion PER MONTH, or some 8% of GDP. The compromise that will enable the economy to avoid the fiscal cliff may be an initial move in that direction, but much more will be needed. Much more cutting of entitlements (anathema to the Democrats) and much more revenue from taxes (anathema to the Republicans ), as well as structural reforms that will require the slaughter of herds of sacred cows (subsidies to farmers, cosseted teachers’ unions, military programs and bases, etc. etc.).
If, as currently seems likely, the politicians do not step up to meet these challenges, the markets will try to ‘persuade’ them, by creating a crisis. One way or another, the next few weeks and months should be interesting times, in the Chinese sense of that term.