By: Andrea Cohen
Over the last few quarters we have seen significant improvement in the US in terms of labor, growth, economic activity and consumer spending and sentiment. Activity-wise, it seems very clear that the US is on the right path to recovery, while most of the rest of the world is either stagnant or in contraction. Why then doesn’t the USD rise more significantly than it has already?
Besides the uncertainty of the closely-tied upcoming November 6th election, which hampers any attempts at a conclusive forecast of administration actions, there is the Fiscal Cliff that looms in the background and is getting closer with each passing day.
The term “Fiscal Cliff” refers to a situation that is currently scheduled to happen on January 1st, 2013, on which date we will witness a sudden reduction in the US deficit (through increased revenue from taxes as well as lower expenditures) to the tune of $607 billion. This situation is predicted (with very high certainty) to be accompanied by a significant economic slowdown. The timing corresponds with the lapsing of a few acts and by-laws put in place by the last two administrations in an attempt to stimulate growth.
The Fiscal Cliff has two major components: taxes and government expenditures.
The tax cuts that are about to expire date back to President George W. Bush’s first term in office. In 2001 and 2003 income tax was lowered as well as the estate tax. These “temporary” provisions are set to expire on December 31st this year. For example, the estate tax will return to 55% on anything over $1mm, from the current rate of 35% on anything over $5.12mm; income tax top rate will jump from 35% to 39.6%. On top of that, taxes related to the 2010 Healthcare Law are scheduled to take effect.
On the other hand, a $1.2 trillion (yes, trillion) cut is expected in government spending on January 1st. That amount and date were set in an agreement between the Democratic President and the Republican Congress in 2011. As part of an effort to agree on raising the debt ceiling of the US government at the time, it was agreed that a “super-committee”, comprised of Republican and Democrat representatives, would be put in place to find a solution to the problem, or put this $1.2tn cut into effect. Well, the super-committee failed to reach an agreement so far and so, the cut is becoming a more and more real possibility. Ironically, the monstrous magnitude of the cut was chosen to force politicians to agree on a way to avert it.
So, what’s going to happen to the US economy?
About half of the spending cut will come from the defense budget. That means huge losses for Aerospace and Defense contractors (Lockheed-Martin, for example), which will likely result in massive layoffs, as well. How the other half of the cut will be “divided” is still not 100% clear, but we can definitely expect to see headcount reductions in government as well.
On the consumption side, there is likely to be a severe adverse effect because households (especially ones that spend a lot) are facing a blow to their disposable (after-tax) income. Bottom line is that we are likely to face a recession (again).
What’s to be done about this?
Well, not much, except more deliberations and publicized announcements. A lot of the uncertainty is a result of the coming elections. As Democrats and Republicans have different views on how to avert a catastrophe here, the identity of the new President and the results of the Congressional elections are of key importance here. Being such a close race makes each side entrench in its positions, and we’ll have to wait to see who will prevail in the elections.
In general, Republicans favor the extension of all the tax reliefs and also the postponement of government spending, especially defense-related spending. Some of it is ideological (taxes) and some political (defense industry), but in general, their stance is to postpone having to deal with the problem.
Democrats are slightly more realistic, though, one can argue, they are also populist. Regarding taxes, the Democratic stance is that rich people (individuals that makes more than $200K a year or couples that make more than $250K) should stop enjoying tax reliefs immediately and that for all others, an extension will be granted for another year (for now).
The Fiscal Cliff is a real and present danger to the American economy. There are different estimations regarding how deep of a recession will follow the cliff, so we see no point in making either doomsday predictions, but there is little doubt that unless government shapes up and starts taking measures to avert this situation, Americans from all walks of life (and probably the rest of the world) will be adversely affected as early as the first half of next year.