In: Uncategorized30 Jul 2012
This is my latest Perspective column for Fund Strategy magazine.
As metaphors go it is a scary one. America is hurtling towards a “fiscal cliff”. The term evokes an image of an economy that is about to do itself serious damage by plummeting from a great height.
The vivid image refers to the impact of the planned tax rises and spending cuts set for the first day of 2013 if Congress does not act to stop it. Among measures that are planned to take effect are the expiry of tax cuts that were first enacted in 2001 and subsequently expanded; the end of a payroll tax holiday; and hefty cuts in both defence and non-defence spending.
According to the Congressional Budget Office, this could cut the federal budget deficit by $607 billion (£387 billion), or 4% of GDP, in one year. The consequent fall in GDP could be a similar amount, or perhaps even higher, according to reputable estimates. America would enter a double-dip recession as a result.
Although there is a strong case for reducing America’s deficit over time, taking such a huge hit in one go is another matter. Indeed, the term “fiscal cliff”, which is generally attributed to Ben Bernanke, the chairman of the Federal Reserve, is designed to get such concerns across.
Global fund managers are certainly worried. According to the latest Bank of America Merrill Lynch monthly survey it is seen as the biggest “global tail risk” by 19% of them. That is less worrying than the European Union’s sovereign debt crisis but well above the danger of a bust in the Chinese real estate market or a conflict between Israel and Iran.
Such concerns are also apparent within America itself and among influential international organisations.
Among American business leaders a good gauge of concern is the “beige book” survey of sentiment published by the Fed. The most recent edition of this regular survey of American businesses showed fiscal uncertainty as a prime worry alongside healthcare costs and developments in Europe and China.
Such fears were also apparent in Bernanke’s recent statement to Congress. After highlighting the potential risk resulting from the eurozone crisis he went on to talk about America’s precarious fiscal position:
“As is well known, US fiscal policies are on an unsustainable path, and the development of a credible medium-term plan for controlling deficits should be a high priority. At the same time, fiscal decisions should take into account the fragility of the recovery. That recovery could be endangered by the confluence of tax increases and spending reductions that will take effect early next year if no legislative action is taken.”
This is not the first time Bernanke has made such statements. He was arguing of the potential dangers of a fiscal cliff at least as far back as February in an earlier testimony to Congress. In March he was quoted as telling a congressional committee that “it is important to achieve sustainability over a longer period…one day is a pretty short time-frame”.
As for international institutions, the International Monetary Fund has led the way in warning of the dangers. It was not widely noticed that the forecasts in the generally gloomy World Economic Outlook update presupposed that America would not tumble over a cliff:
“The projections … assume that current legislation in the United States, which implies a mandatory sharp reduction in the federal budget deficit – the so-called fiscal cliff – will be modified so as to avoid a large fiscal contraction in the near term.”
In its accompanying Fiscal Monitor update the IMF spelt out its preferred course of action. It said that a fiscal cliff, which it estimated would imply a fiscal withdrawal of 4% of GDP, “would severely affect growth in the short term”. It argued that “a more modest retrenchment – of around 1 percent of GDP in structural terms – would be a better option”.
As it happens, the IMF’s relative optimism on avoiding the fiscal cliff is probably, although not definitely, justified. The American authorities seem to be engaged in a dangerous game of chicken where dramatic cuts are threatened in the hope of gaining acceptance for more gradual reductions. In some respects it is likely the public relations trick of leading with an outrageous story in the expectation that a merely bad one will seem acceptable in comparison will work.
The need to find the right balance was recently spelt out in a report from the bipartisan “Committee for a Responsible Public Debt” appropriately entitled: “Between a Mountain of Debt and a Fiscal Cliff”. It argues that the two extreme options – falling over a cliff or allowing debt to continue to expand rapidly – are both unwise and that it is necessary to take a more gradual and thoughtful path of debt stabilisation and eventual reduction.
As with so many debates in economics, this focuses on the wrong problem. The large fiscal deficit is a symptom of a more fundamental economic weakness rather than its cause.
The American authorities have kept public spending artificially high as a way of avoiding a restructuring of the real economy. They have preferred to keep things ticking over, through the expansion of credit, rather than create the basis for a new round of investment.
A more apt metaphor than the cliff might be that for three decades America has been riding a fiscal balloon in an attempt to escape difficult choices. The balloon has reached stratospheric heights so it needs to come back down to earth before too long. It is time for its passengers to tackle some tough challenges.
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