Fear beyond a fiscal cliff
Markets will remain fragile until a compromise is reached over the US fiscal cliff, but Washington faces a huge problem in getting the budget to balance regardless of the outcome.
It is a large amount at any stage of the business cycle but is especially so when the US is only slowly recovering from the banking and housing crash, with GDP at a tepid 2 per cent and the unemployment rate close to 8 per cent.
Obviously President Obama and Congress will need to make sure that there is no fiscal cold turkey with the lapsing spending and tax cuts, which are embedded in the fiscal cliff. The shock of such a fiscal contraction would almost inevitably see the economy dip back into recession.
This is why US markets are so skittish. Since the election on Tuesday, US stocks have fallen by around 3 per cent and the 10-year bond yield has dropped to around 1.6 per cent. The clear concern is about a new recession if Congress and Obama can’t see a way to deal with the fiscal consolidation.
Overnight, the IMF joined the debate over the fiscal cliff. It spooked markets with its judgment that there is a "medium probability” the government will not find a solution before the end of the year. In a paper that was presented to the G20 Finance Ministers meeting last weekend, the IMF report noted that: "Even if the fiscal cliff were quickly unwound, the damage to the economy could be substantial, especially if consumers and businesses were faced with continued uncertainty about tax and spending policies."
In a stark assessment of the risk, the IMF also suggested that: "A last-minute deal that relies on suboptimal fixes or largely kicks the can down the road may ultimately prove harmful.” In a worse case, the IMF even noted that the US government risked a "technical default” if Congress failed to present a credible fix to the fiscal problem.
What is being lost in the debate is the still urgent need for the US to fix its fiscal position. The budget deficit is around 7 per cent of GDP and net government debt is 84 per cent of GDP and rising. Spain has a lower public debt to GDP ratio.
It is a truism that if the US is to fix its budget and move towards a balanced budget, taxes must be hiked and spending must be cut. The fiscal cliff is actually a wonderful manifestation of a quick fix to the problem.
But the issue at hand is the size of the potential shock and the fact that a divided Congress makes all policy changes difficult to deliver. The Republicans are keen to see the tax cuts extended, but are demanding additional spending cuts as the means to reduce the budget deficit. The Democrats, somewhat more constructively, are willing to embrace some spending cuts but are also arguing that the tax side of the budget be used to boost the revenue base and move the budget back to balance.
The markets will be fragile for the next seven weeks or at least until there is a compromise on the issues behind the fiscal cliff.
The debate highlights how poorly planned a range of Bush administration tax cuts and defence spending programs were. They were fiscal times bombs, all designed to hit in 2013 and therefore be there for someone else to fix.
By way of comparison, the fiscal consolidation measures being delivered in Australia are, in terms of their impact on GDP, not that much smaller than the US fiscal cliff. This no doubt accounts for the obvious cooling in the economy in recent months.
In Australia, the fiscal consolidation is a little over 3 per cent of GDP in 2012-13, not far shy of the 4 to 5 per cent US fiscal cliff that is causing market and political ructions. What is different in Australia is that the consolidation is occurring with a backdrop of solid economic growth and low unemployment. The measures contributing to the record fiscal turnaround were well planned and were framed to be temporary when the stimulus was implemented in the flurry of the global financial crisis.
The "temporary, timely and targeted” stimulus measures, as former Treasury Secretary Ken Henry liked to call them, have all finished. It is the "temporary” nature of the fiscal measures during the GFC that is the key point here.
There are no more $900 cheques in the mail, the 'Building the Education Revolution' has all but finished and programs like the insulation or 'pink batts' scheme have ended. These policies accounted for the move to budget deficit – the absence of these measures, plus a range of spending cuts, account for the fiscal contraction now underway.
For the US, there was no such planning and hence little policy flexibility. There is a strong desire to see the economy keep growing, as there should be, but there is also a requirement to fix the budget. The fiscal cliff highlights the incompatibility of those two objectives.
Whatever solution there is to the fiscal cliff in the next few weeks, the US will still have a huge policy problem in getting the budget back to balance without risking an extended period of very sluggish growth or, in a worst case, recession.