Is America going to plunge off a fiscal cliff? That is the question starting to preoccupy Washington and Wall Street. For as fiscal issues move to centre stage in the 2012 election, America potentially faces three nasty shocks.
On January 1 2013, the Bush-era tax cuts are slated to expire, just as automatic fiscal tightening measures, agreed last year, kick in. That equates to about $400 billion in tax increases and almost $200 billion in spending cuts, more than 4 per cent of gross domestic product. If that was not bad enough, in early 2013 America will also hit the $16.4 trillion debt ceiling, which means the Treasury cannot issue more bonds unless Congress raises that limit.
Little wonder, then, that American business leaders expressed a slew of worries about that 'cliff' during recent earnings calls. Or that many are appealing for bipartisan action to offset this potential shock. As Lloyd Blankfein, head of Goldman Sachs, recently observed, "the fiscal cliff [creates] major uncertainty on the world”. Indeed, Morgan Stanley says that 40 per cent of companies are delaying investment because they fear that a big recession will loom if America hurtles off that ledge.
But amid all this hand-wringing, there is another, more subtle – but more likely – threat that ought to worry investors. If the first scenario is an unrestrained plunge, then this second is the fiscal equivalent of bungee jumping. There seems little chance of a bipartisan fiscal deal before the November 6 election and it is anyone’s guess whether a deal can emerge during Congress’s lame duck session (before the start of the next presidential term in January). But even without such a deal, most Washington observers believe a reprieve will emerge just before – or after – January 1. Washington might tiptoe to the edge of that fiscal cliff, in other words, or even appear, temporarily, to go over the edge; but if history is any guide, a last-minute compromise will then pull the situation back. What really looms, then, is a period of brinkmanship, stop-start crises and fiscal swings of the sort that might spook even a professional bungee jumper.
Does this matter? Diehard optimists might insist not. After all, Washington has experienced plenty of this before. Its structure of government, with all those checks and balances, almost encourages it. Last summer, for example, the federal government flirted with a technical default on its bonds because Congress could not agree to extend the last debt ceiling – until there was a reprieve. In the Spring, parts of the government even briefly shut down because no budget was passed. Similar shutdowns also occurred in 1995 and 1996 under President Bill Clinton, as well as in some states.
There is little evidence that this brinkmanship caused lasting economic damage. Precisely because it has occurred before, government agencies have become good at coping. Indeed, some officials insist – somewhat optimistically – that the next bout of brinkmanship might actually be less traumatic than before. Democrats and Republicans have now been discussing – or arguing about – fiscal issues for two years, the argument goes, and while there has been no deal, it has clarified the contours of the debate and opened channels of communication. The so-called 'gang of six senators' who tried – and failed – to broker a bipartisan fiscal compromise last year, for example, are now talking again in an enlarged group (known as 'the gang of eight' or 'gang of 40'). That might enable a deal to be reached quickly – if a crisis struck. "Everyone knows we have to deal with this,” insists one senior administration official.
Nevertheless, what makes the current situation potentially more costly than before is not just the degree of political polarisation, but the wider climate of market unease. With business and consumer confidence already low and sapping economic growth, it is a bad moment for stop-start crises, particularly if drawn out over a long time. Yet, unfortunately, this extended brinkmanship is exactly what markets now appear to expect. A recent survey by Citigroup, for example, suggests that nine out of 10 equity analysts think the US government will deal with the cliff by delaying the fiscal tightening measures temporarily, thus deferring the hard decisions until late 2013. It seems likely that brinkmanship could breed even more brinkmanship further down the road.
Perhaps this is better than going over a cliff but, if nothing else, stop-start crises tend to produce sub-optimal budget decisions. Or, as Rob Portman, the Republican senator from Ohio, recently commented: "The threat of government shutdowns bullies lawmakers into approving poorly drafted, budget-busting spending bills.” More perniciously, the worse this brinkmanship becomes, the more it tends to erode market trust, creating the risk of an eventual accident that sparks a market panic in Treasuries or other asset classes. As the president of a regional Federal Reserve bank observes: "If you are going to go bungee jumping, again and again, you had better hope that the rope will hold.” Investors – and politicians – take note.
Copyright The Financial Times Limited 2012.