Forget the fiscal cliff – there’s a much bigger threat out there

Happy New Year!

Broken any of your resolutions yet? If not, well done.

If so – well, never mind. You’re in good company.

With their last-minute deal on the ‘fiscal cliff’, US politicians have proven yet again that government promises to cut spending are about as reliable as our own annual vows to do more press-ups, eat less cake, and stick to 21 units of alcohol a week.

It seems the ‘cliff’ was more of a speed bump than the precipice that everyone had dreaded. But what does the deal mean for your money?

We’ll be back at the cliff edge in a couple of months

Cast your minds back to August 2011. That summer, the US lost its AAA credit rating. Why? Because politicians couldn’t agree on what to do about the country’s huge debt pile.

Back then, the Democrats and the Republicans were squabbling over raising the federal debt ceiling above $14.5 trillion. The debt ceiling is a completely arbitrary legal ceiling on the amount of money the US government can borrow.

When it was first introduced, the idea was that it would act as some sort of brake on government spending. Instead, it’s simply been raised every time a government has decided it wants to spend more.

On this occasion, however, the conflict was more bitter. The ceiling was raised, but only after both sides agreed to a package of automatic spending cuts that would come in from 2 January 2013 – ie today – unless politicians agreed on an alternative deal. On top of that, ‘temporary’ tax cuts introduced by George W Bush were also set to expire at almost the same time.

So Americans would be paying more tax, while government spending would be slashed. That promised to be a painful dose of austerity, which many believed would send the economy tumbling back into recession.

Understandably, markets were nervous about such an outcome. That’s why they’ve all shot up this morning after a deal was reached last night in the US.

But what’s the deal?

So far, the Bush-era tax cuts have been kept for everyone except Americans who earn more than $400,000 a year (or $450,000 for families). Meanwhile, the automatic budget cuts have been delayed for at least two months.

In other words, they’ve ‘kicked the can down the road’ yet again. Given that the point of all this panic was to cut spending, it’s hardly an impressive outcome. Various proposals floating around until now had looked at ways to cut between $2trn and $4trn over ten years from the national debt. As it stands, this ‘fiscal cliff’ deal will actually add $4trn to the debt over ten years.

Amusingly enough, it also means that in just two months’ time, America’s politicians will find themselves back where they were in August 2011. They’ll be squabbling over whether to raise the debt ceiling, and how to cut spending. Only this time, the national debt will be up at $16.4trn, not $14.5trn.

This is the problem. As Reuters points out, the fiscal cliff is now turning into more of a mountain range to be navigated. Once the February deadline is passed, there are other deadlines in March. And at each of these turning points, Republicans will be calling for spending cuts, and Democrats will be looking for tax hikes.

It’s not quite as bad as the rolling crises we’ve seen in the eurozone over the past few years, but there’s more than enough potential drama to keep markets on their toes over the coming months. That means you can expect plenty of noise and artificial panic and headline-grabbing on this topic between now and March at least.

Forget the day-to-day drama – the end-game is inflation

As an investor, you need to take a step back from all this. What have we learned from Europe, or even the UK’s own attempts to cut? It’s that when push comes to shove, politicians would rather not take the hard choices.

The path of least resistance is the inflationary path. That means loose monetary policy – which we already have almost everywhere – and loose fiscal policy, where possible. Like everywhere else, the US would much rather inflate its way out of trouble, rather than repay its debts or live more within its means.

So you can expect deals to be reached every time the politicians meet up. Even if it means the fiscal cliff face just keeps being shunted further off into the future.

Meanwhile, monetary policy will remain extremely slack. As regular contributor James Ferguson explained in MoneyWeek magazine recently, this is an increasingly risky path for the US to take.

Before, quantitative easing (QE) offset deflationary pressure. But now that the US economy is no longer on the brink of collapsing into a black hole, QE could turn out to be far more inflationary. It won’t be obvious at first. But by the time it is, it’ll be too late to reverse course. James discussed this topic in more detail at our recent New Year roundtable. You can read the whole thing in the next issue of MoneyWeek, out on Friday.

Given our concerns about inflation, we’d keep holding gold in your portfolio as insurance. But we’d also be keeping a tight hold of your Japanese investments. If one country would actively benefit from inflation, it’s Japan. And new boss Shinzo Abe seems determined to make it happen. The value of the yen has plunged since he took power, and various lobbyists are now pushing for it to weaken even further.

But it’s not just about the weak yen – our roundtable experts also give their views on the other reasons to be upbeat about Japan in the next issue. If you’re not already a subscriber, now’s a great time to start – subscribe to MoneyWeek magazine

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  • uncommercial

    The US debt ceiling isn’t arbitrary and wasn’t introduced to put a break (sic) on debt. The constitution gives Congress the sole power to authorise state borrowing, and Congress originally had to approve every new issuance of debt. Putting an overall ceiling on US government debt was a way to make the system more flexible in 1917, related to the costs of war. The legislation set a ceiling on total borrowing, in cash terms, which has naturally needed amendment on account of inflation. Latterly, this has become a political football. Almost all economists agree that inflation is a good thing, although only in moderation.

  • Ellen

    Happy New Year to Moneyweek. And well done Merryn on Moneybox for highlighting government intervention being the main driver of the economy – and not market forces.

    The US never had any intention of sticking to the agreement reached in mid 2011 and the further we get mired in this crisis, the more it resembles games of ‘chicken’ or ‘poker’. It is very scary how much of the wealth of the world is ending up in so few hands.

    I agree that ultimately inflation or defaults (or both) will be the end game but, by then, the majority will be facing a lifetime of servitude or the Tottenham riots will become regular features all over the world.
    My new years is to see senior politicians to display more courage and more conviction and not pander to various lobby groups for election purposes.

  • Chester

    Inflation may be the path of least resistance, and politicians and central bankers may be under the illusion they control outcomes. But we have a deflationary spiral because social mood is in charge, not meddling fools with illusions of how an economy should behave. Inflation will eventually happen, but not until significant debt destruction has re-balanced financial systems. The meddlers are prolonging a natural process which they are powerless to stop, not reversing it

    Abe will be up against bond holders and the financial markets, who ultimately control real interest rates. He may be determined to spark inflation, but it has defied all previous attempts over 2 decades. Why? Social mood and demographics in Japan, despite the desired outcome of QE or Govt “strategy”

  • smlaing

    This looks much like the floods of the New Orleans. The flow of water being printed money, The flood barriers being the banks holding back circulation. But what I see is the eventual hurricane of money overwelming the flood barriers. The money will eventually circulate, but not in the country of origin.

    The powers that be want exactly this. Their objective was to buy up the worlds core assets keeping velocity as low as poss, then let the flood gates open thus destroying the debt the money originated from.

    The absolutely want inflation, but only when they are ready for it and ignorant masses are not!

  • MtnGoat

    Hey John — Did you know that single quotes are always incorrect in English (except for very rare cases like nested quotations)? Please put a “break” (sic) on them, as they make MoneyWeek look very amateurish.

    And re comment #1, the debt ceiling is NOT required by the US Constitution. In fact, many in Congress as well as many economists think it should be abolished, because it has been reached about 75 times since 1960 and has been raised every single time, so what is the point? Only in 2011 was there a huge fight over raising it, so Obama is absolutely in the right in insisting that he will not negotiate or accept any preconditions when it is reached around March 1. The Republicans have started using the debt ceiling to blackmail the country into enacting measures that they cannot pass by majority vote, which is despicable, especially because they voted to raise the debt ceiling over 30 times under Republican presidents.

  • Bob

    So if it is inflation then, what, gold and silver to buy? What about equities?

    Wouldn’t inflation lead to rising IRs which, in turn, bring down stock markets?

    Or will rising IRs be the last thing that happens – long after cash has been eroded to nothing?

  • uncommercial

    @MtnGoat – Nobody said the debt ceiling was required by the US constitution. But Congress (and only Congress) explicitly has the power to borrow money on the credit of the United States. Article 1 Section 8. The debt ceiling came about in time of war as a way of allowing the executive to manage individual fund raisings while still leaving overall control of borrowing with Congress, as required by the constitution.

  • Myki

    so the US is ultimately going to stoke inflation and with a different presentational style, the UK will follow. debt devaluation using inflation as the tool.

    reminds me of the 1970s. i know some of you won’t agree, but its time to load-up with debt to finance asset purchases and let inflation corrode it away.

  • Tintagel

    My understanding is that the debt ceiling was breached a few days ago and the Treasury Dept. are now dipping into the various govt pension funds to keep paying the bills.

  • Ellen

    @ Tintagel. I did not know that but am surprised at how ready I am to believe it – and I do.

    Wasn’t there a huge scandal in the early 1990s when newspaper magnet, Robert Maxwell, used his employees pension pot to prop up his business. The media, government, unions and public were enraged and laws were enacted to prevent further abuse of such powers.

    It tells you how our moral compass has changed after becoming accustomed to seeing people who are entrusted to positions of power continuously abuse that power whenever it suits them.

  • synicalbugger

    To quote Ellen “My new years is to see senior politicians to display more courage and more conviction and not pander to various lobby groups for election purposes.”Well I’d love to agree, but the way I see it, you blag your way into major position in politics, you blag your way in that position for say 5 Years,you get you a massive state backed inflation linked (RPI not CPI)linked pension, then you get voted out, write a book and get some part time job at half a million a year on the back of your political success. Why do they need to solve anything?

  • Boris MacDonut

    #11 Not only is your name offensive, it is mispelt.How did it pass the thought police? Perhaps you are on the staff.