What you need to know about the fiscal cliff

US financial markets are getting increasingly concerned about the so-called "fiscal cliff” and what it might mean for the economy at the start of 2013. US stocks markets have now fallen for four straight weeks and bond yields are dropping back towards fresh record lows. The reasons for the concerns have validity when one considers what the fiscal cliff is.

In its most simple form, there are a large number of government spending programs and temporary tax cuts that end on 31 December 2012. This is because of the fact that when they were introduced, there were designed to be temporary measures that did not permanently increase the budget deficit.

The problem now is that the looming tax rises and spending cuts will take a lot of cash out of the US economy on January 1, 2013 if left unchecked. According to the Congressional Budget Office, the cumulative impact of the spending and taxation items will take $503 billion from the economy over the course of 2013. This amounts to a hit of around 4 per cent of GDP.

The main problem is that this is occurring when the economy is muddling along in the aftermath of the banking and financial crisis with GDP growth barely at 2 per cent, with the unemployment rate still hovering around 8 per cent and with significant headwinds for the US coming from the global economy. The fiscal cliff is simply too big to take in a single hit.

The green shoots of recovery slowly showing up in housing, parts of the labour market and business investment could quickly be snuffed out with a hit this big to economic activity. This is especially the case when monetary policy in the US is snookered with interest rates already at zero and quantitative easing taking a long time to yield material economic benefits.

Indeed, it was the chairman of the US Federal Reserve, Ben Bernanke, who coined the phrase "fiscal cliff”.

In February 2012, when appearing before the House Financial Services Committee, Bernanke was being questioned about the general fiscal outlook and in particular was asked about the structural budget deficit and government debt imbalances confronting the US.

While acknowledging the importance of getting the budget deficit under control over the medium term, Bernanke said: "I think you also have to protect the recovery in the near term. Under current law, on January 1, 2013, there's going to be a massive fiscal cliff of large spending cuts and tax increases. I hope that congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date.”

Bernanke's concerns and direct warning to congress were clear, but he went on, "I have expressed concerns about what would happen on January 1 [2013], which would be a major fiscal contraction. I think it would pose a risk to the recovery. What I have advocated is a two-part process, one which is critical that we have a sustainable path going forward in the medium and long term, but that at the same time we pay attention to the recovery and make sure we don't snuff it unintentionally."

Those words from Bernanke nine months ago ring true today. They are one reason the Fed recently extended its quantitative easing policy to have a program of unlimited bond purchases with a concentration of mortgage backed securities – the economy is vulnerable.

Professor Paul Krugman does not share all of Bernanke's concerns. For Krugman, the issues surrounding the fiscal cliff are not from the perspective of fiscal policy being too loose or that government debt is too high, but rather fiscal policy will be too tight and government debt too low even if the fiscal cliff is watered down.

Krugman is suggesting that the US economy does not have the fundamental strength to withstand even a fiscal pot hole, let alone a cliff. Krugman is not all that concerned with government debt and budget deficits and he cites government bond yields as a reason for his lack of concern. He has a point.

Bernanke still sees a need to reduce the budget deficit and repair government finances, but in an orderly manner. In his view, failure to move fiscal settings to a sustainable path could be catastrophic. At the same speech back in February, Bernanke said, "once the markets lose confidence in the ability of the government to maintain fiscal sustainability then there are numerous risks. The most extreme case would be a financial crisis or a sharp increase in interest rates analogous to what we see in some European countries.”

Amid all of the debate and discussion of fiscal policy, it is important to note that the US still has a huge fiscal problem. Net government debt is currently at 84 per cent of GDP and is forecast to rise over the next three years. The budget deficit is still well above 5 per cent of GDP and significant policy changes are needed to fix the fiscal position. The question is increasingly how rapid the move to a balanced budget and debt reduction should be.

The fiscal cliff is akin to going "cold turkey” on tax hikes and spending cuts. The budget would be on the fast track to repair but it would be at a huge cost to the economy. Unchecked, this fiscal policy risks returning the economy to recession. This is why congress and President Barack Obama are still likely to compromise on the policy changes that make up the fiscal cliff. Policy will be tightened, but for the sake of economic growth in the US, the speed of the change should be slowed dramatically.