US economy heading for fiscal cliff

US President Barack Obama has less than two months to broker a deal with the Republicans to prevent crippling budget cuts

By Larry Elliott  /  The Guardian

Sun, Nov 11, 2012 - Page 9

Politics in the US is about to go from knife edge to cliff edge. The closely fought battle for the White House is over, but the battle to prevent the US economy from nosediving back into recession is about to begin.

US President Barack Obama has less than two months to broker a deal with Republicans on Capitol Hill to prevent budget cuts of US$607 billion of national output kicking in on Jan.1.

The “fiscal cliff” was barely mentioned during the presidential race, but the world is now going to hear about little else.

Why? Because jumping off the fiscal cliff is seen by Wall Street, the City of London and the IMF as the biggest threat to the global economy over the next year, dwarfing even the risk that a Greek exit from the eurozone would start the unraveling of monetary union in Europe.

The US, despite the rapid growth of China in the past two decades, remains the world’s biggest economy, accounting for just under 20 percent of global output. The Congressional Budget Office (CBO) in Washington has estimated that the planned tax increases and spending cuts would reduce US GDP by 4 percent next year, dwarfing the scale of UK Chancellor of the Exchequer George Osborne’s austerity program, which has involved budget tightening of between 0.5 percent to 1 percent of GDP per year. To emulate in Britain what could be in store for the US, the chancellor would have to halve the NHS budget or put £0.10 on the basic rate of income tax.

Removing 4 percent of US GDP would have profound implications when the wounds from the deep downturn of 2008-2009 have yet to heal. The CBO believes it would wipe out forecast growth and result in the US economy contracting by 0.5 percent next year — although many economists say it would be far worse than that.

The fear is that demand in the US would collapse, unemployment would head back toward 10 percent and the tentative recovery in the housing market would be thrown into reverse. Global trade flows would dry up, already shaky banks would nurse bigger losses, there would be a more rapid cooling of the Chinese economy, and the chances of a fragmentation of the eurozone would massively increase.

These threats are so obvious and so imminent that economists expect Obama and Republicans on Capitol Hill to come to a settlement between now and the end of next month.

Although the relationship between the White House and Congress has been at best tetchy and at worse poisonous in the past four years, the expectation is that minds will now be concentrated.

“Although the economy is improving, it is too fragile to cope with such a shock. The likelihood is a compromise, extending some combination of the tax and spending programs. Although that would still not be constructive for growth, at least it would not as bad as the worst case,” Standard Chartered Bank’s chief economist Gerard Lyons said

“In addition, it would remove the uncertainty, although, as on previous occasions, we are likely to see some nervousness until the year-end about whether things will be agreed in time,” he added.

Two thirds of the planned budgetary tightening come from tax increases, something the Republican majority in the House of Representatives will find hard to accept.

The expiry of former US president George W. Bush’s tax cuts alone are expected to raise US$221 billion, with a further US$95 billion to come from the end of the payroll tax rebate. Tax rates will increase for those earning more than US$70,000 a year, with the top rate of income tax rising to 39.6 percent.

The rest of the plan involves spending cuts totaling more than US$1 trillion over the next nine years. Each government department will have its discretionary spending trimmed by 10 percent, although mandatory entitlements such as social security and Medicare would not be touched.

Democrats say that it would be foolish to cut spending when the economy remains weak, particularly given the poor state of the US’ public infrastructure.

“The basis for a deal to avert the fiscal cliff remains clear. Democrats are likely to agree to extend the tax cuts for high income earners in exchange for Republicans agreeing to delay the spending cuts,” US analysts at Capital Economics Paul Ashworth and Paul Dales said.

However, they added that this would amount to postponing the fiscal cliff without tackling the underlying problems and thus lead to further credit downgrades from the ratings agencies — Moody’s, Standard and Poor, and Fitch — early next year.

The US shrugged off losing its prized “AAA” rating last year, but the impact of a second downgrade might be to increase the cost of government borrowing and to push down the value of the US dollar.

Some fiscal tightening of policy is inevitable. Neither Democrats nor Republicans have expressed a desire to extend the payroll tax rebate holiday, while the cost of Obama’s healthcare plan will add US$18 billion to the nation’s tax bill next year.

Compared with the eurozone, where falling output this year is expected to be followed by a year of stagnation, the US is in reasonable shape. The economy is growing and US competitiveness is being boosted by cheap energy from shale gas. Some manufacturing capacity is being brought back to the US and there is the prospect of energy self-sufficiency within a decade.

However, in the short term the chances are that growth will remain sluggish and unemployment slow to come down. Deficit reduction, even if modest, will result in the US Federal Reserve keeping monetary policy ultra loose. Interest rates will remain at rock-bottom levels deep into Obama’s second term and the US central bank will consider further doses of quantitative easing to boost money supply.

This assumes the fiscal cliff can be avoided.

Obama won his second term despite what had happened to growth, jobs and living standards in the past four years. A majority of US citizens were unhappy about the state of the economy, but still gave the president a second chance. In the end, it was not the economy, stupid.

However, it is about to be.