Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: US President on edge of fiscal cliff

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If all of the tax cuts expire and all of the spending cuts take effect, the superpower could tip into recession.

President Barack Obama. Photo / AP
President Barack Obama. Photo / AP

Spend any time at all looking at the United States' fiscal numbers and it is hard to escape the conclusion that the land of the free is also the land of the free-loader - so wide is the gap between what Americans expect their Government to do for them and what they are prepared to pay for in taxes.

As long as the election loomed their political leaders have had a powerful incentive to dodge the task of putting the US Government's finances on a credible path to sustainability.

It is a challenge as daunting as it is pressing.

The Federal Government has just recorded its fourth annual deficit in a row north of US$1 trillion. It borrows one dollar in every three it spends.

The US Treasury warned last week that it could hit the debt ceiling of US$16.4 trillion (equivalent to more than 100 per cent of US gross domestic product) by the end of the year.

The Congressional Budget Office estimates the Federal Government will spend US$3.8 trillion on interest payments alone over the next 10 years, and that is under its baseline projections which assume that current laws remain unchanged.

In other words it assumes that the US will mark the new year by jumping off the "fiscal cliff" into recession.

It probably won't, of course, but it is one of those low probability, high-impact events the possibility of which makes financial markets nervous and in the real economy encourages companies to defer investment and hiring.

The fiscal cliff arises because several time-limited measures are all set to expire at the same time.

They include tax cuts brought in under the Bush Administration. The two parties agree that those which benefit the middle class should be extended but differ on whether those which benefit the wealthy should be.

The Alternative Minimum Tax, originally aimed at the wealthy, is set to hit the middle class as well.

Both parties agree that is a bad idea, as is a scheduled cut in payments to doctors under Medicare, the taxpayer-funded health care support for the elderly.

Some measures introduced by the Obama Administration in the wake of the global financial crisis, notably suspension of some payroll taxes, are due to expire and both parties agree they should.

In addition there are some swingeing spending cuts legislated last year at the time of the debt ceiling crisis which are due to kick in in mid-January unless a legislative override is agreed.

Part of the deal to kick for touch then was to legislate those cuts, which would affect constituencies dear to hearts of both Republicans and Democrats. The idea was to incentivise a "super committee" of legislators from both parties to come up with a durable fiscal bargain.

It failed.

In the worst case scenario, if all of the tax cuts expire and all of the spending cuts take effect, the US would be faced with a fiscal contraction of between 4 and 5 per cent of gross domestic product, more than enough to tip the world's largest economy into recession. But Christian Hawkesby, head of fixed income at Harbour Asset Management, says that rather than think in binary terms - will they or won't they plunge off the cliff - we should think in terms of a range of outcomes representing various degrees of fiscal contraction. And we should not think of the end of the year as a drop-dead date, as there are a variety of measures available to a lame duck Congress to, as the cliche has it, "kick the can down the road".

Hawkesby puts the odds of the best case, a grand bargain, at 10 per cent and the worst case, over the cliff, at 5 per cent.

In between are more plausible outcomes clustered around a fiscal drag of 1.5 to 2.5 per cent of GDP.

Offsetting that is extraordinarily loose monetary policy, with the Federal Reserve having committed to keep its policy rate near zero and to continue quantitative easing until it has a high degree of confidence there has been a sustainable recovery in the jobs market.

The majority of forecasters canvassed by Consensus Forecasts are picking the US economy to grow in the 1.8 to 2 per cent range next year, reflecting the view that the politicians will muddle through, coming up with a deal that does not knock too much off GDP growth, Hawkesby says.

AMP Capital chief economist Bevan Graham is also confident the US is not going to swan-dive off the fiscal cliff.

"We know it is not going to happen. All we don't know at the moment is how it is not going to happen."

But resolution of the fiscal cliff will still leave the bigger issue of coming up with a credible plan to achieve long-term fiscal sustainability.

That will not be easy.

Three big-ticket items make up two-thirds of the US budget: defence spending, social security (the US is already well on the way to raising the age of eligibility to 67) and Medicare and Medicaid.

All three represent powerful constituencies, likely to get more powerful as the population ages.

Meanwhile, there is a deep-seated aversion to tax increases among Republicans if not, indeed, among Americans generally.

But American exceptionalism does not extend to immunity from the laws of arithmetic.

"The lack of a comprehensive fiscal plan is really what got Europe into its problems, at least with the markets, because they didn't believe it had the will to fix anything," Graham says.

"The US is no different, other than that they can print money and that money is the world's reserve currency."

However, this will be playing out at a time when US economic fundamentals are starting to look, if not stronger, at least more stable, Graham says.

"The improving housing market is having a positive impact on consumer confidence and the stability of consumer spending.

"On the downside, however, we know businesses have been delaying hiring and investment decisions on the back of fiscal uncertainty. That will continue to be a drag on growth until the fiscal landscape is more certain."

The International Monetary Fund's forecast for global growth next year is now 0.5 percentage points lower than it was in April.

The latest forecasts are predicated on the assumption that the euro debt crisis and US fiscal issues will be addressed satisfactorily and that if they are not "global activity could deteriorate very sharply".

Reserve Bank Governor Graeme Wheeler said yesterday that no one wanted to see a fiscal contraction of 4.5 per cent of GDP in a US economy growing at a rate of around 2 per cent.

"You want a signal that the US is serious about fiscal consolidation in the medium term, given its debt ratios," he said.

"But you don't want a significant drag on the economy in the short term, because the US is 21 per cent of world output and what happens to its rate of growth is still tremendously important for Europe and for ourselves."

- NZ Herald

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