Item one on President Obama’s agenda: don’t fall off the fiscal cliff

6th November 2012

President Barack Obama will hardly have time to get his feet back under the desk in the Oval Office before he faces a huge economic and political challenge, popularly known as the fiscal cliff.

Fiscal policy, which refers to a government's tax and spending measures, doesn't usually involve anything as steep as a cliff. But even though it is a media construction, the term is quite a good way of describing the current situation in the US.

The fiscal cliff is a combination of tax rises, Bush era tax cuts that are due to expire and automatic spending cuts already agreed by the US government. The US arrives at the cliff edge itself on January 1 next year.

US fund manager Fidelity says it could amount to as much as five or six per cent of GDP while the non-partisan Congressional Budget Office's report on the matter says America risks falling back into recession if it doesn't deal with the cliff.

With America's fragile recovery at stake this has huge repercussions for the rest of the world. It could see America suffering a renewed political and economic crisis, just as world bond and stock markets are getting a little more confident about the Eurozone.  

Just before the election, the Washington Post reported on three scenarios outlined by Fidelity, a short term compromise that might, for example, extend some tax cuts, a grand bargain that deals with many of the medium and short term issues and a failure to achieve a compromise or in other words America falls of the cliff. The last of these is clearly the worst case scenario for the rest of the planet and for the President in his second term..

While it is bad news generally, Fidelity has also considered sectors that could be hit by a failure to deal with the issue. These include defence and healthcare, sectors reliant on Federal government spending.

The reason the fiscal cliff presents such a big hurdle President Obama, is the extreme polarisation of US politics with tax and spending policies one of the clear dividing lines.

Obama may be able to work with a likely majority Democrat Senate, but the House of Representatives is almost certain to return a Republican majority, and they tend to view almost any compromise on tax and spending as a complete betrayal of their principles. Many have promised, in successive election campaigns including this one, and speeches in the House, never to vote for tax rises.

In a similar vein in 2011, the world witnessed a stand-off between Congress and the President over raising the debt ceiling, at the time compounding economic uncertainty in the US and elsewhere.

If anything, this US election, widely described as the most polarised in recent American history has poisoned the well even further.

Even had Mitt Romney won, some commentators were predicting a similar ideological stand-off, with US website Talking points memo (TPM) warning a new debt ceiling crisis. That exact possibility has disappeared along with Romney's chances, but once the cliff is dealth with, more arguments about the debt ceiling may occur next year.

Certainly the people who manage money are worried.

Last month, a global survey of fund managers by Bank of America/Merrill Lynch found that 72 per cent do not believe the fiscal cliff has been priced into global equities and macro economic data.

The 'cliff' was also viewed as the number one 'tail risk' – by 42 per cent of respondents.

In layman's terms, a tail risk means there is an increased chance that a portfolio will move beyond three standard deviations of what is expected, and in this case that would be almost certainly down. The term is explained in more detail on Investopedia.

On Seeking Alpha, Jeffrey Rosen, an economic forecasting expert who developed his own model, says that until it is resolved it almost impossible to rely on any economic forecasts for the US economy.

Not everyone has such a bleak view, or at least not everyone believes that investors can do much about it.

Just prior to the election, the Wall Street Journal's MarketWatch columnist Howard Gold suggested that apart from a handful of leading politicians no-one really knows what will happen. He concludes: "When nobody knows anything, the best thing to do is nothing at all. That's why I think all this brouhaha over the fiscal cliff is just noise that investors can safely ignore."

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