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Should investors worry about the US fiscal cliff?

| 29 November 2012

Should investors worry about the US fiscal cliff?

The National Debt Clock in Manhattan, an electronic billboard displaying estimated US debt in real time, was suspended in 2000 for a couple of years. It had trouble running backwards to reflect the declining debt caused by budget surpluses. Today, the worries of a decade ago seem odd. The clock is ticking up faster than ever (recently topping $16 trillion) with the US government spending about 56% more than it took in revenues last year - a budget deficit of $1.3 trillion.

Now the US election is over, and President Obama has secured a second term, attention is turning to the so-called "fiscal cliff", a combination of tax hikes and spending cuts coming into effect on 1 January 2013. They involve the expiration of tax cuts in the George W Bush era coinciding with automatic reductions to military and domestic spending. To date, President Obama has planned to force high earners to pay more taxes and plug the gap, but Republicans have so far been against these proposals.

Deficit reduction - surely a good idea?

Anything that serves to reduce the deficit and slow the growth of the debt burden is surely good news? Not necessarily. If nothing is done the fiscal cliff could, by some estimates, reduce economic growth from 2% in 2013 to around zero - much more severe than the effect of 'austerity' measures in the UK. In a worst-case scenario it could mean a severe recession, completely undermining the Federal Reserve's open-ended quantitative easing (QE) policy.

Despite the proximity and gravity of the situation, a political consensus on the fiscal cliff may not be forthcoming. Many Republicans argue that maintaining tax cuts is unsustainable, but nobody wants to pay more taxes, and every exemption or credit has vocal supporters. On spending too things look tricky. So-called mandatory programme-spending ordained by federal law such as Social Security, Medicare and Medicaid accounted for 88% of government revenues in 2011. These programmes can only be changed by an act of Congress, so cuts in other areas or tax increases simply have to be made.

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Market implications

Markets have thus far taken the impending fiscal cliff in their stride. Mathematically, it is easy to solve through extending current tax policies and preventing spending cuts. Yet politically it could be more difficult - at least until the US has actually gone over the fiscal cliff, something of a misnomer in itself as the effects of the measures will take effect gradually rather than simultaneously. Many predict legislation will be enacted to ameliorate the effects of the fiscal cliff at the 11th hour, or even after the event, as a result of urgent negotiations. This would probably be enough to keep the markets on an even keel, but there could still be plenty of nervous moments as the cliff edge approaches and politicians appear to be at loggerheads.

Of course this doesn't resolve the wider issue: that debt, when it gets too big, can debilitate an economy and constrain economic growth. The US government currently spends 10% of its revenues servicing debt, a relatively small proportion as a result of the ultra-low interest rates it enjoys. Persistent deficits and rising debt-to-GDP mean these rates can only last so long. Eventually something will have to give on both the revenue and spending sides of the equation. Deficit reduction is ultimately a good thing for longer term economic stability, which is why a parachute jump off the fiscal cliff rather than a hard landing is the best the market can hope for. I believe this is likely to be largely priced into the market presently, and any clarification of efforts to address the fiscal cliff is likely to be well-received.

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