Fiscal cliff: What if we go over the deadline?

A guy jumping What are the consequences of jumping over the cliff?

After almost two years, a game of fiscal chicken between President Barack Obama and Republicans in Congress is reaching its final moments.

In 2011, Mr Obama's administration tried to raise the US government's borrowing limit - the "debt ceiling" - which is set by statute.

But disagreements with Republicans over the government's borrowing levels led to a compromise that meant automatic spending cuts and tax rises would be triggered on 31 December 2012 if no broader deal was reached.

That so-called "fiscal cliff" is approaching fast and still no deal has been made.

What are the various scenarios for what could happen next?

NO DEAL IS REACHED

On 1 January, tax cuts from the George W Bush era expire and huge spending cuts kick in. Some $607bn of cuts and tax rises are planned, including:

  • Reductions in the defence budget
  • The end of a 2% payroll tax cut
  • Changes to allowances for Medicare - medical care for the elderly
  • Reductions to some family income credits for the poor
  • The so-called "alternative minimum tax" extending to many taxpayers
  • The end of long-term federal unemployment benefits - at about $300 a week - which immediately cuts off about 2 million people

This need not spell immediate disaster. But over time, it would have a painful effect on the US economy, which is recovering but remains weak. Many observers say these measures would amount to a 4-5% cut in the country's output.

Unemployment is just below 8%. It could start to climb again as businesses - dealing with more tax and a less rosy future - cut back on hiring.

The head of the US central bank, Ben Bernanke, has said that going over the cliff could send the economy "toppling back into recession". Mr Obama has also said that in the past.

The Congressional Budget Office has predicted the US will fall into recession and unemployment would jump more than 9% in 2013 if leaders can't agree a way out of the cliff.

JP Morgan economist Michael Feroli has estimated that more than $550bn could be sucked out of the economy and the US-based Tax Policy Center (TPC) estimates that the average annual tax bill for each American would rise by $3,500. The super-rich face an average tax rise of $120,500 a year, while the lowest earners will see an increase of about $412.

Another recession in the world's largest economy would be a huge blow to the rest of the world, which is not exactly problem-free.

Does letting the spending cuts and tax rises kick in mean that the US government will run out of money?

No. The the Treasury secretary said that he would be able to create about $200bn in wiggle room that would normally last about two months. So the date at which the government runs out of money is not imminent.

But the US is supposed to reach the debt ceiling - the total amount of debt that the government can borrow, which is currently $16.394tn - on 31 December. So unless a deal is made to extend it, that ceiling will be reached at some point in the near future.

During the last stalemate over the debt ceiling, ratings agency Standard & Poor's downgraded the country's top-notch AAA credit rating to AA+ for the first time ever. More ratings cuts are likely to happen.

But ratings agencies are not all-powerful - especially when it comes to the fate of the world's largest economy.

Whereas you would expect the value of US government debt to fall during such a stand-off - as people fear a default - it actually gained in value during the final month of the debt stand-off. Part of this came from hope that a deal would be reached but more was based on the fact that the US is so important and still perceived to be the safest place to be.

The US is a haven for investors when the world is in trouble - as it is currently, with low growth rates and Europe struggling with a debt crisis and grinding recession - and even when it is not. The country is currently the "least bad alternative", in the words of one Bloomberg News columnist.

This is one of the reasons why - despite the ballooning deficit and weak economy - the US dollar remains strong compared to its other counterparts. It reached a two-year high against the yen on Thursday, for example.

Still, stocks worldwide fell during the last stalemate so the effects will probably be felt again in January on share indexes if the government looks close to running out of money again.

The IMF has calculated that the immediate neighbours of the US, such as Canada and Mexico, stand to lose the most from the fiscal cliff.

"But China and several advanced countries would also suffer up to one quarter of the hit taken by US growth," it added. China is the world's second-largest economy.

It also predicts a drop in commodity prices - of between 6-12% for energy and 3-6% for non-energy such as food prices - would affect exporters of these goods. For most markets, the US remains the largest importer so any drop in demand is felt throughout the world.

A COMPROMISE IS REACHED

Mr Obama has offered several deals to Republicans - with the proviso that taxes on the wealthiest people must be raised.

John Boehner briefs the press Republicans want more spending cuts that Democrats are balking at

He had insisted that taxes must rise on all those earning in excess of $250,000, but offered to raise that threshold to $400,000.

He also offered a change to the way Social Security cost-of-living adjustments are made for some recipients, cuts to government healthcare programmes, and called for a two-year extension of the debt ceiling. But these were rejected.

The Republican Speaker of the House, John Boehner, also offered to allow the tax cut to expire just for those earning more than $1m as part of a compromise "Plan B" offer but that was rejected by his own party.

With many mainstream Republicans now accepting higher taxes and Mr Obama coming off a solid election victory, there is a chance that the leaders can reach a short-term deal that combines agreeing a budget that is politically acceptable with extending the debt ceiling.

In that case, it would depend on how long the agreement lasts. If it lasts another two years, then it is likely to calm financial markets for the time being and delay the fight again to after the US mid-term elections.

Any impact of the terms of the deal are also unclear. It is unlikely that the rise in taxes would have much of an effect but any spending cuts by the government could have a wider impact on the economy depending on what is agreed.

For example, it is likely that any deal would include some eventual cuts to social security which would have an impact on consumer spending. Likewise to other items up for discussion, such as an increase or cut to the capital gains tax.

But whether political brinksmanship or not, many Republicans in the House of Representatives remain unwilling to accept any deal that raises taxes.

A GRAND BARGAIN IS REACHED

This would require a hostile Congress to co-operate with Mr Obama, as any deal must pass through both houses of Congress and be signed by the president.

But grand bargain - one that locks in a long-term solution to the debt ceiling and begins to cut the huge US public debt - could be so unexpected at this stage that it would likely boost the financial markets.

What it would involve is something like a plan to cut $4-5tn in debt over the next 10 years - a deal that unites Democrats and Republicans over the best way to bring the US debt down and avoids the likelihood that we have to have these political battles every two years.

What are people willing to accept as part of a grand deal?

According to a poll published last week by Slate, conducted by YouGov of 1,000 Americans, what citizens are prepared to accept are "higher taxes, cuts in government services, and military downsizing" while preserving Medicare and social security.

This, clearly, is not being discussed.

But a deal of this kind and this magnitude that lowered the US debt over the next decade remains the most hoped-for outcome in all these discussions between the two main US political parties.

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