We are all looking over the cliff

John Burman

Published — Monday 19 November 2012

Last update 19 November 2012 3:17 am

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YOU may not know it, but your life will be directly affected by what happens in the US over the next six weeks. This is far from normal. It is true that political clout, military strength, and a pervasive popular culture mean the US is unarguably the most influential country in the world. But in the run up to Jan. 1, 2013, when a swathe of tax increases and spending cuts are scheduled to knock $ 640 billion out of the US economy, all eyes should be on Washington. If, as predicted, these measures tip the US back into recession, we will all suffer.
The US economy still produces a quarter of the world’s output. That means it does not matter if you live in Los Angeles, Beijing or Cairo; wherever you are your life will be affected by the success or failure of the US economy. As the US begins to suffer from relative economic decline, the world reliance on the US economy to drive growth is certainly decreasing. Let us not forget that the European Union economy taken as a whole is even larger than the US economy, considerably so in fact. But in terms of one single, national economy, the US still beats them all and still matters a great deal. China may be catching up, but it has just registered its seventh successive quarter of declining growth.
This is why we should all take note of what Ben Bernanke, chairman of the US Federal Reserve, called the "fiscal cliff" earlier in 2012. Basically, a series of fiscal laws, some dating back to the Bush era, but some as recent as 2011, if left unchanged will mean that measures originally designed to boost the economy will expire on Jan. 1, 2013. A variety of tax cuts will come to an end and across-the-board government spending cuts will come into force. If left in place for all of 2013, the total impact will be equivalent to 5 percent of GDP — the economy only grew by 2 percent last year! Of course, it would have the effect of drastically reducing the deficit — by roughly half in fact — but the shock to the system would instantly damage fragile growth and US unemployment would shoot back up.
The January 2013 fiscal cliff was in essence designed to be a cut off point by which US lawmakers would come to an agreement on how to reduce the ballooning deficit safely. Back in 2011, when this question was last looked at in detail, there was political stalemate. The conclusion of those deliberations was that tax hikes and huge spending cuts would be mutually undesirable to both ends of the US political spectrum, so everyone agreed that the threat of introducing these measures — now just a few weeks away — would encourage a compromise solution.
The looming fiscal cliff was barely mentioned during the recent US presidential elections. Why? Perhaps because no side looked good for having agreed to it in the first place. The fact that the day after President Obama was re-elected, the markets fell steeply on concerns that the cliff was now in sight shows that it was clearly on everyone’s mind, it just was not being discussed.
The point is though, that it is not only the US that suffers from this uncertainty. Just as the Dow index plummeted immediately after the election, so did all the other world’s markets, even in the Middle East. World markets have fallen by over 5 percent in a few weeks. Of course, other factors are at play: The recent corporate earnings season has not given investors a clear indication of where the world economy is going; there are renewed fears about the fate of the euro zone; and now we have the conflict in Gaza. But the stock market’s recent problems all began on Nov. 6, when the long presidential campaign came to an end and thoughts turned to the cliff.
Three weeks on from the presidential election, talk is of an agreement between Democrats and Republicans over how to avoid falling off the cliff. Naturally, such issues cut to the heart of modern politics: how much should a government tax and how much should it spend. I am simplifying the respective positions a bit when I say that Republicans generally want to avoid tax hikes while Democrats want to avoid spending cuts. Getting the opposing sides to agree a compromise related to their core political beliefs is not easy.
As if this was not bad enough, the US debt ceiling might be reached before the end of 2012, meaning that, in theory at least, the US government will not be able to repay interest on the national debt. That might be the unlikely worst case scenario, but the last time the US came close to the debt ceiling, in August 2011, the US economy was shortly after downgraded and global markets fell sharply.
My view is that if no agreement is reached on how to avoid falling off the fiscal cliff, world stock markets will experience a total fall of about 20 percent from the levels they were at when President Obama was re-elected. At a 5 percent fall, we are currently only a quarter of the way through that process. The positive news is that the chances of the cliff being avoided are extremely high: no-one wants to see the US economy slip back into recession, not least US lawmakers. And in the worst case scenario, if the measures do come into force, they will probably only be temporary. The key problem is the uncertainty all this causes. As any business owner will tell you, if you cannot forecast you will not invest. Simple as that. Congress, over to you.

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