What is America's 'fiscal cliff' and why does it matter?

Now that the US election is over, attention has turned to the dangers of the so-called ‘fiscal cliff’. What is this, and why does it matter for investors? Matthew Partridge investigates.

What is the fiscal cliff'?

US President Barack Obama faces perhaps his biggest domestic challenge so far the US fiscal cliff'. For the last decade the US government has been spending more than it receives in revenue, creating an annual deficit. This year's is expected to be $1.1trn, equivalent to 7% of GDP.

Meanwhile, a toxic combination of tax rises (mainly reversals of previous tax breaks given to employees and businesses) and spending cuts are due to come into effect by the end of the year, unless Congress and the president can agree to defer them.

If not, the Congressional Budget Office (CBO), the official US budget watchdog, estimates that extra tax revenue and state cost cuts will see the budget deficit plunge "by $607bn, or 4% of gross domestic product [GDP], between fiscal years 2012 and 2013". Dropping off this fiscal cliff will cut the annual deficit by an eye-popping 5.1% during 2013.

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Would falling off the fiscal cliff really be so bad?

Most economists argue that slashing the deficit this fast will backfire. While the CBO accepts total national debt levels (in effect the cumulative annual deficits added together) would start falling within two years, the US economy would also be plunged back into recession in the first half of next year.

Unemployment would peak at 9.1%, reducing tax revenue and forcing the government to spend more on unemployment insurance. That would reduce the planned deficit reduction by $40bn.

As temporary tax breaks reverse, company profits and consumer spending would both be hit. Dirk Hofschire of Asset Allocation Research estimates that "corporate earnings could decline by double digits". This would have a "tremendously negative" effect on the stockmarket.

How bad is the US deficit?

Not everyone thinks the fiscal cliff is a problem. William Gale of the Tax Policy Center argues that an enormous fiscal contraction would put the US "on a budget path that deals with the deficit quite well over the medium term and the long term".

And failing to tackle the deficit might be worse than suffering the pain of heading over the cliff. If you include the debt held in public pension funds, the US debt-to-GDP ratio is 102%, the highest it's been since 1947 and larger than the eurozone average of just below 90%. Within another decade it could be 20% higher.

The CBO warns that an ongoing deficit will reduce the resources available for productive investment, lead to interest payments on debt taking a larger share of the national budget and make it harder to use fiscal policy to tackle future crises.

It also warns that mounting levels of public debt increase the risk of a sudden fiscal crisis where lenders suddenly panic and US borrowing costs spike. Any delay in dealing with US debt will "reduce output and income in the longer run relative to what would occur if the scheduled fiscal restraint remained in place".

What do the politicians think?

Getting agreement on this problem isn't easy given that the Democrats control the White House and the Senate but the Republicans still control the House of Representatives. All three need to agree for a deficit reduction deal to take place.

The Financial Times's Gavyn Davis thinks that, despite their differences, both parties know that "a large fiscal tightening will be needed in the long term". But he also believes that neither side "wants to implement all of this tightening in 2013".

Davis predicts a compromise that would cut the deficit by $200bn, halting the rise in the debt-to-GDP ratio without plunging the US economy into recession. This would then be "followed by full implementation of the cliff when the economy is assumed to have recovered in 2015".

However, while Capital Economics also expects a deal, it thinks it will be weaker and merely consist of keeping the status quo on both taxes and spending. That's tantamount to "kicking the fiscal can further down the road".

What impact will this have outside the US?

America is not the only country facing its own national debate about the pace and extent of deficit reduction. Attempts to deal with the eurozone debt crisis have led to brutal recessions in several Mediterranean countries. Even relatively modest cuts in Britain have been blamed for the double-dip recession.

However, as Der Spiegel points out, the contraction implied by the US fiscal cliff is unprecedented. "Not even the crisis-ridden countries of the eurozone have instituted such drastic austerity programmes" Meanwhile, the International Monetary Fund has warned that it would "inflict large spillovers on major US trading partners".

Some German economists think it could "result in a global loss of confidence that would lead to a collapse in investment worldwide". The stakes could hardly be higher.

A grand bargain rejected

Two years ago Barack Obama set up the National Commission on Fiscal Responsibility and Reform, chaired by Erskine Bowles (a former Clinton aide) and Alan Simpson (a former Republican senator).

At the core of its plan was the idea of simplifying the tax system by cutting rates and eliminating deductions. Another proposal would have shored up the state pension system by increasing the retirement age and payroll taxes. Finally, Bowles-Simpson also suggested cuts to various industry subsidies and defence spending.

However, the Congressional Research Service argued that even these measures wouldn't be enough "to shrink the deficit on anything close to the scale called for". The committee's grand bargain' proposals were rejected.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri