Who’s afraid of the big bad cliff?

The automatic spending cuts and tax increases that threaten to send the globe's largest economy back into recession.

The problem of the fiscal cliff has everyone from international investors to our own finance minister worried. For South Africa, there is concern about what the cutbacks could mean for trade and its growth plans.

The US treasury in its medium-term budget policy statement warned that failing to address the fiscal cliff was one of the "principal risks to the strength of the global recovery".

Meanwhile, a recent survey of investors on the Chicago Board Options Exchange indicated that worry about the US fiscal cliff had become paramount, overtaking a concern about other major global events, including the eurozone debt crisis.

Despite the rising tide of fear, economists and analysts argue that, should sense in US politics prevail, a solution to the problem can be found.

The fiscal cliff essentially amounts to two elements. The first is the expiry of a range of tax breaks, some going as far back as 2001, which will end in January 2013. This is combined with looming automatic cuts in government spending as the US federal government reaches the legally set limit of how much debt it may take on to fuel its budget deficit. The figure is set at $16.4-trillion and is referred to as the "debt ceiling".

The spending cuts were set down by a 2011 statute, the Budget Control Act, which was passed after US legislators, divided by party politics, were unable to address the problem of the growing budget deficit and resulting government debt.

Supportive government
The International Monetary Fund has estimated that the automatic tax increases and spending cuts could amount to $700-billion.

Should US politicians and ­policymakers not find a solution, the combined effect of a swath of tax increases and an end to supportive government spending could result in the US economy contracting by an estimated 4%, plunging it back into a recession, said Kevin Lings, an economist at Stanlib.

A solution will require the support of Republicans and the Democrats in the US legislature. But, after an acrimonious election race, there is concern that political brinkmanship could scupper bipartisan attempts to solve the problem.

Obama's administration has emphasised its desire to ensure that the looming tax increases apply to the nations wealthiest individuals, whereas Republicans are opposed to any tax increases.

The "sequester" or automatic cutbacks in spending will not be a once-off event, according to Lings. Instead, they will be multilayered across a range of programmes, from defence to social spending, and will be on a multiyear basis.  

But there are options available.

Tax cuts
In the case of taxes, US leaders could put off the decision until they can reach an agreement over which tax cuts should expire versus which should continue. The decision could be put off until early 2013 and, once made, the chosen tax increases could be implemented retrospectively.

But a means to head off the spending cuts is required more urgently, he said, because the US federal government was likely to reach its debt ceiling in December. Should this happen, the US government would be unable to take on more debt, because this would break the law. And because the spending cuts take effect automatically, a delayed decision could not be implemented retroactively. "If the full 4% [contraction] is allowed to hit the US at once, it would plunge it back into recession," said Lings.

Had the US economy been performing better, the impact of going over the so-called cliff would be more modest, he noted. The country had been achieving growth in the order of 2%, but it was fragile.

If the problem is not resolved, second-round effects will begin to unfold, resulting in companies cutting back on inventories and staff and setting off a downward spiral from which the US economy might find it difficult to recover.

Corporations in the US had cut inventories over the past nine months, along with curtailing fixed investment, said Lings. Employment numbers had remained stable, but companies were not taking on more people.

In contrast, US consumers appeared unfazed by the threat of the fiscal cliff, he said. This might be because the implications might not yet be fully understood.

US consumer confidence is at its highest level in five years.

Pre-emptive response
There was the risk that the longer politicians took to find a solution, the more likely a "pre-emptive response" could come from consumers, Lings said. They would curb spending in anticipation of higher taxes and a decrease in benefits.

There are a number of scenarios available to US leaders. In the first they can simply "muddle through", choosing to postpone decisions to 2013. But this was not ideal, Lings said, because it would serve to push the problem further out, increasing the likelihood of pre-emptive action by consumers and corporates.

Alternatively, a compromise could be reached, he said, including passing legislation to increase the debt ceiling while negotiating a measure of tax increases.

The result could be some fiscal consolidation and a retraction of an estimated 1%. This would result in a slowdown in the US economy, but it would not spark a recession, while allowing the US to gradually reduce its already high and unsustainable debt levels over time.

Taking no action would amount to "economic suicide", Lings said.

Hung Tran, deputy managing director at the Institute of International Finance, said failing to deal with the fiscal cliff would have implications for emerging economies such as South Africa because they are still dependent on world trade.

He was speaking at a media briefing following the inaugural Africa Financial Summit held by the institute in Cape Town this week.

Given the recession in the European Union and Japan, the global economy would weaken and world trade would plummet if one began in the US. As a result, the efforts by many emerging economies to resume growth through monetary stimulation would be blunted, he said. But Tran said the fear of the fiscal cliff was "overblown" and a "misnomer". Although it was a risk, it might turn out to be a smaller one than feared by market participants.

It was much more likely that some configuration of measures would be agreed, ensuring that the amount of fiscal contraction at the end of the year would be much smaller than the estimated $600-billion.

The institute estimated that a reduction of about one-third, or $200-billion, would be effected, resulting in a contraction of an estimated 1.1 percentage points of gross domestic product. This would be "welcome", because the US government has to bring its fiscal deficit and government debt under control.

After the re-election of President Barack Obama, with a comfortable electoral and popular margin, the dynamics had changed, said Tran, and despite the political rhetoric, both Democrats and Republicans had indicated that a compromise could be reached after the election.

"It is critical that Obama get Republicans on board," said Catherine Grant, head of the economic diplomacy programme at the South African Institute of International Affairs.

There was a growing tide of opposition to the tax benefits the country's wealthiest continued to enjoy, even among ordinary Republicans, Grant said, suggesting that some kind of compromise might be reached.

Goolam Ballim, chief economist at Standard Bank, said there was a blend of options available, such as select tax increases, especially for the wealthy, as well as a measured approach to federal expenditure cuts.

The core message of the 2008 global economic crisis, however, was that the world was "intimately wired". Any stutter in the performance of an economy the size and heft of the US would be felt by South Africa either directly or indirectly, he said. "Matters of US fiscal health are as close to us as the jugular."

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Lynley Donnelly
Lynley Donnelly
Lynley is a senior business reporter at the Mail & Guardian. But she has covered everything from social justice to general news to parliament - with the occasional segue into fashion and arts. She keeps coming to work because she loves stories, especially the kind that help people make sense of their world.

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