Footholds in a crumbling fiscal cliff

The promise of fiscal cliff compromise is a ray of hope for markets fearful of prevaricating politics. But Congress needs to act quickly to ensure 2013 is a good year for the US.

Markets got some relief when it was announced that the US House of Representatives would be meeting on Sunday, December 30 to discuss and potentially vote on the fiscal cliff issues that were dogging sentiment and risking a period of economic weakness into the new year.

It is not clear, at this stage, what fiscal plans will be brought to Congress, let alone pass. But in an otherwise souring outlook for the budget negotiations, the promise of compromise was seen as potentially welcome news.

In a positive sign, Republican House Speaker John Boehner said that Republicans would "act on” what the Senate passes in terms of the fiscal cliff package.

US stocks had been falling sharply and bonds rallying strongly as the absence of definitive progress on the fiscal cliff spooked financial markets. A sharp 9 per cent fall in consumer sentiment in December, to a level of just 65.1 points, only made matters worse.

The fiscal policy brinksmanship was risking tax increases and spending cuts, totalling $US600 billion – or more than 4 per cent of GDP – beginning on January 1, 2013. The fear for markets and most sober analysts is that such a dramatic fiscal policy contraction concentrated in one big hit will severely damage a US economy that is still fragile, subdued in the aftermath of the banking and financial crisis that started in 2007.

Until the apparent compromise broke late in the US trading day, the core of the problem was the Republican Party’s unwillingness to accept even moderate increases in taxes and for all the fiscal policy focus to be on spending cuts, to fix US budget and government debt positions which remain weak and in need of repair.

US President Barack Obama, who cut short his Christmas holidays to negotiate the policy changes needed to avert the worst effects of the fiscal cliff, will no doubt be pleased to see signs of compromise from the Republicans. Obama has offered Congress a modified and revised fiscal proposal but it still has significant tax increases on the very highly paid as part of the package, as he works to keep his election promise and simultaneously address the parlous the budget position.

The Republicans had been opposed to tax hikes to the point where they were refusing to accept even a weak proposal to limit the tax increases to those earning more than $US1 million per annum. The current fiscal cliff has tax increases for those earning $US250,000 a year.

The other issue still spooking markets and drawing out the worst aspects of the political win-at-all-costs approach being played by the Republicans is the need for Congress to approve an increase in the US government debt ceiling. The markets recall the experience of 2011 when legislation to raise the government debt ceiling was postponed by the Republicans. This action which ran the risk of the US government being unable to pay its bills and worst still, defaulting on its debt, led to Standard & Poor's downgrading the US credit rating and sparked a 6 per cent drop in US stocks in just a day.

US Treasury Secretary Timothy Geithner wrote to Congress yesterday saying that he would take "extraordinary measures” to ensure the government was able to function as government debt levels rose through the current level of the ceiling. Geithner also said, rather chillingly, that "given the significant uncertainty that now exists with regard to unresolved tax and spending policies for 2013, it is not possible to predict the effective duration of these measures”. In other words, Congress needs also to work quickly to ensure the debt ceiling is raised and the US government can pay its bills and not risk defaulting on its debt obligations.

The best outcome in the fiscal cliff and debt ceiling talks would obviously be a blend of tax hikes for the very high income earners, some spending cuts and for Congress to rubber stamp the increase in the debt ceiling. Any extended impasse risks undermining what are increasingly positive signs about the US economy, with the housing sector on a clear path to recovery and consumer demand also edging higher.

It must also be highlighted that whatever contractionary effects on the economy come from fiscal policy, the US Federal Reserve will offset these by the continued implementation of the easiest monetary policy ever seen in the US.

It did look like 2013 would be the best year for the US economy since before the banking and housing crisis started to unfold in 2007. This is at risk due to the shenanigans over fiscal policy and debt. The year 2013 still can be – and should be – a good year for the US economy, but it needs Congress to act quickly and fairly in dealing with fiscal policy and not play games with the debt ceiling.