Cliff Edge

09/11/2012 at 5:00 pm

Fiscal cliff.

It doesn’t sound pleasant. But what does it actually mean?

What it meant on Wednesday in the aftermath of the US elections was the biggest one-day fall in the S&P 500 for five months, the biggest rise in Treasury futures since April and global risk contagion through equity, debt and commodity markets.

What it means for the US economy is that an automatic programme of tax increases and government spending cuts will kick in at the end of the year. The programme was the result of the debt ceiling crisis reached in 2011: Congress has the constitutional “power of the purse”, Republicans had taken control of the House in the November 2010 elections, and they refused to allow the Treasury to borrow any more money unless agreement was reached to reduce the budget deficit at some point. The automatic programme is clumsy, politically unsatisfactory to all concerned, and relative to the colossal government borrowing involved not as hugely material as some coverage might lead one to believe. But Congress hasn’t managed to agree anything better since a year ago, so for the time being America is stuck with it.

It is understandable that rather less attention was paid to news from Europe on the same day. The EU Commission published its autumn economic forecast, and there was some comment on the fact that expected growth for the eurozone next year has been revised down since the spring from sluggish (+1.0%) to flat (+0.1%). European stock markets had already fallen on the back of this information before descending further as the US took its little bath.

At the same time, however, the zone’s 2013 budget deficit is looking to be in better shape. Originally projected at 2.9% of GDP it is now forecast at 2.6%; bearing in mind the reduced growth forecast this just shows how much progress has been made in bringing budgets under control. Gross government debt to GDP is forecast to peak at 94.5% next year.

Let’s compare this to figures in the US.

According to the Congressional Budget Office (p. 22 here), the assorted terrors of the Fiscal Cliff would see a deficit of 7.3% of GDP this year fall to 4.0% in 2013 and draw level with the eurozone at 2.4% a year later. In this scenario, debt to GDP would peak in 2014. Growth should be expected to suffer. However, the CBO also publishes an “alternative fiscal scenario” (a.k.a. do nothing). While salvaging near term growth, this scenario would see the deficit crawl down to 4.2% of GDP over the next five years before deteriorating again as debt service costs rose. The level of debt to GDP wouldn’t peak at all – it would just keep rising indefinitely.

It is painfully ironic that eurozone governments have been accused of “kicking the can down the road” in addressing the burden of sovereign debt. These states have been taking serious action to improve their books for some time. One can of course argue the rights and wrongs of the trade-offs involved, and observe that they have been acting out of necessity. But it has always been an obtuse criticism.

In contrast, the US government in 2011 kicked the can all the way to 2013. With New Year around the corner the can is in sight once again – and there are plenty of pundits arguing that what’s required for the time being is another kicking. At the same time most politicians seem to recognise that budgeting for an eternal increase in the ratio of debt to GDP is insane.

We have long argued that fears over the US economy have outpaced reality. Budgetary worries are not baseless and it is understandable that markets are concerned. And yet as of this week jobless claims continued to fall, consumer confidence reached a new five-year high, and third quarter earnings for the S&P 500 reported so far are on average 4.7% up on a year ago (above initial expectations and higher than the 4.0% increase in nominal GDP over the same period). We observed recently that Britain’s status as a safe haven was questionable on fundamental grounds but should survive if the world economy continues to muddle through. In budgetary terms the same goes for the United States.

Still, it is worth taking this week’s market movements seriously and thinking a little about the alternative. What we experienced on Wednesday was the tiniest taste of what would begin to happen if markets were ever to decide that it isn’t the European model, or the single currency, but western social democracy as a whole which is no longer economically viable.


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