All you need to know about the fiscal cliff



Now that the US Presidential election is over and this month’s ECB meeting has ended, there is something new that the news media will be focusing on moving towards the end of the year.  First we dealt with the “troika”, then there was the BRICS, then the PIIGS.  Now we have a new buzz word.  Ladies and gentlemen, grab your climbing gear.  We are about to explore “The Fiscal Cliff”.

The “Fiscal Cliff” is the popular shorthand term that has been used to describe the problems that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws that are going to change when the new year begins are the end of last year’s temporary payroll tax cuts.  This wil result in an increase of 2% of taxes for workers.  It will end certain tax breaks for businesses.  Shifts in the alternative minimum tax will mean a larger bite, and there will be an end to the tax cuts from 2001-2003.  We will also begin to see taxes that are related to President Obama’s health care law.  While all this occurs, spending cuts that were agreed on as part of the debt ceiling deal of 2011 will begin to go into effect.  This will also affect over 1,000 government programs that include the defense budget and Medicare that will fall in line for “deep, automatic cuts”.

According to analysts, lawmakers have three choices when dealing with the fiscal cliff and they do not think any are particular attractive.  The first choice calls for allowing the current policy that is scheduled for 2013 to begin.  This includes a number of tax increases and spending cuts that would weigh heavily on U.S. growth, and could drive the economy back into a recession.  On the plus side, the deficit as a percentage of GDP would be cut in half. The second alternative would include canceling some, possibly all of the scheduled tax increases ad spending cuts.  This would add to the deficit as well as increase the odds that the United States might face a crisis that is similar to the one taking place presently in Europe.  The other side of this choice is that US debt continues to grow.  Choice number three would be following a course that heads down the middle, an approach that would address the budget issues to a limited extent, but would have less of an impact in groeth.

Listening to legislators the last few days, once would hope a compromise could be reached. As we get closer to the cliff, the end of the year, investors continue to be concerned as the current political environment does not lend confidence to a compromise being reached.  This problem has existed now for the past three years but nothing has been accomplished.  So where are we?  Republicans want to cut spending and avoid raising taxes.  Democrats are looking for a combination of spending cuts and tax increases.  Everyone wants to avoid the cliff, but due to the election, thoughts of a compromise have been put to the side.  Now that the election is over, both sides will look for solution.  Will there be an eleventh hour solution? Or will we have to wait for the next Congress to be sworn in on January 3rd?

What will probably happen is that Congress will come up with another set of stop-gap measures that would delay a permanent policy change.  

If the current laws that are expected to go into effect in 2013 occur, there could be a dramatic impact on the economy.  The deficit would be reduced by an estimated $560 billion, GDP would be cut by 4 percentage points in 2013, that would put the economy into recession.  Unemployment would rise by a full percentage point and we would lose about two million jobs.

It will be interesting to see how both sides of the political fence play this out the last few weeks of 2012.  The term “cliff” indicates an immediate fall or disaster that would occur at the beginning of 2013.  But the changes will take place over the entire year.  How the Congress acts will depend on the type of “deal” that can be worked out before the end of the year.  Congress will eventually act, it just might not at the beginning of 2013.  Stay tuned, there will be more on this as we move towards year end.

 Further reading: 5 Reasons Why Greece Could Leave the Euro-Zone After the US Elections




About

Matthew Lifson is a Foreign Exchange Trader and a Market Analyst. with Cambridge Mercantile Group.

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