Monday, 24 December 2012


Okay, I know that lemmings do not actually all commit collective suicide by running over a cliff.  It was a made up piece of film by Disney.  But, that just shows that lemmings apparently have more sense than US politicians.  With seven days to go, and Congress having gone away on holiday, it looks pretty certain that the US is going over the "Fiscal Cliff".

There are reasons why politicians on both sides of the aisle, now believe that going over the cliff offers them an acceptable option.  On the one hand, Obama now never has to get elected again.  he can hold out, and blame the Republicans for failing to agree with his proposals.  Democratic politicans, two years away from their own elections, may also have an advantage in blaming the republicans for failing to compromise, and thereby imposing large tax rises on the majority of US workers, for the sake of their demand that people earning more than $250,000 a year, also get a tax break.  Opinion polls seem to suggest they are right, US voters will blame the Republicans for failing to compromise.

But, Republicans have a reason for going over the cliff too.  Their leader Boehner was unable to get support from Republicans for his proposal "Plan B", that would have introduced temporary measures of tax rises, and spending cuts.  The plan would in any case have been voted down by the Democrat dominated Senate, and vetoed by Obama.  It was an attempt by Boehner to put the blame on the Democrats.  But, his own side scuppered even that.  Under pressure form the Tea Party, who have hog tied themselves with a commitment not to raise taxes, enough Republican Congressmen opposed Boehner's plan that he would not have even been able to get it passed Congress let alone the Senate.  Boehner himself is now under threat from the Tea Party.  It is a sijmilar position that Cameron finds himself in in the the UK, squeezed between Social Democratic Tories and Liberals on one side, and the ultra-Right Tories and UKIP on the other.

For Boehner, if the US goes over the Fiscal Cliff, it is a way out.  The Fiscal Cliff means that the existing tax cuts end, and a series of spending cuts are introduced automatically.  That means that, the republicans will not have actually voted for any tax rises!  On the contrary, in the negotiations that follow, which will reintroduce tax cuts for the majority of US citizens, they will legitimately be able to say they only voted for tax cuts!!  Moreover, in two months time, the issue of the US Debt ceiling raises its head again.  That is a limit on how much the US Government can borrow.  Republicans see this as a second bite at the cherry.

US politicians seem relaxed about going over the cliff for that reason, and for others.  The idea has taken hold that going over the cliff will not be that serious because, the cliff will in fact be more like a slope.  That is, the full effect of the fiscal contraction - estimated at around 4% of GDP - would only take full effect over a twelve month period.  So, in fact, the reduction of aggregate demand in the first month would only be about a twelfth of that.  They beleive that a deal would be arrived at, long before the full effect was felt.  This seems misplaced to me.

Firstly, although the full 4% of GDP hit would only arise after a full year, on a proprtional basis, the hit to GDP for January would be about the same.  In other words, if the hit to GDP is 4% of the annual figure, then the hit to the monthly figure for GDP is also likely to be around 4%.  That can be mitigated by using balances, reserves and so on, but in turn these then have to be restored in future months after any deal is done.  But, for ordinary workers, already overstretched as a result of the debt built up over the last 30 years, they may not have such balances and contingencies to draw on.  With ordinary workers trying to reduce their own indebtedness, the only recourse to the tax increases they will face in January, will be to reduce their spending even more.  That will have an immediate impact on aggregate demand.

But, there is a further aspect to that.  As I pointed out two years ago in relation to the Liberal-Tory austerity measures, and their doom mongering, applying the fiscal brakes too early has costs way above the immediate reduction.  If you are pedalling a bicycle, once you have got it up to a decent speed, so that you can use top gear, the effort of keeping it at that speed, and raising it, is much less than if you are starting from a standstill.  By, the same token, if you apply the brakes, and reduce the speed before you have reached that speed, you will have to again put more effort in than had you not braked.  The same is true with an economy.

Fiscal and/or monetary stimulus is needed where the economy is operating ata  sub-optimal level, with unused resources, because of insufficient demand, lack of confidence etc.  Once it reaches an optimal level, no further stimulus is required, and in fact measures of fiscal contraction can be safely introduced to prevent overheating.  At that point, the growth in the economy becomes self-sustaining, it acheives a level of momentum, just like a bike.  But, applying the brakes, as the Liberal-Tories have done in the UK, and as the Tea Party would do in the US, prevents that momentum building.

Going over the Fiscal Cliff would have exactly that effect, even if a deal was done on the budget in the next couple of months.  Already, we have seen consumers and businesses cutting back on their expenditure, and losing confidence, because of the uncertainty due to the negotiations over the cliff.  If the US actually goes over the cliff then that is likely to be exacerbated.  We have now had around 3 years, when uncertainty has led to capital hoarding profits as money hoards rather than it going to productive investment.  The effect of that on the economy has itself added to the uncertainty faced by consumers, who have restrcited their own consumption, and attempted to reduce their debts.  Without that, even the US economy, which has performed better than Europe, would have grown by considerably more than it has.

Finally, the Republicans believe they will have second bite of the cherry over the debt Ceiling, but there is no reason that Obama and the democrats will do a deal over the Debt ceiling separate from a Budget deal if the US goes over the cliff.  That would be imbecilic.  Obama would be in the driving seat, able to demand that Republicans as part of any Budget Deal also agree to a significant increase in the Debt ceiling to go with it, if not abolition of the ceiling - which is a ridiculous instrument anyway - altogether.  That means that if the US goes over the cliff, and given the opressure the Republicans will be under from the Tea Party, a deal may take some time to be reached.

The Republicans are now effectively holding no effective cards.  The democrats can propose tax cuts for the vast majority of Americans, leaving the Republicans to veto it, for the sake of a few very rich people.  The democrats can insist on a comprehensive deal that incorporates the Debt Ceiling with a package of tax rises on the rich, and targeted spending cuts that can be spread over a ten year period.  The possibility seems to be that this might even split the Republican Party, as more moderate Republicans decide to vote with Democrats to get a deal done, whilst the Tea Party and its entourage hold the line.  It could be a preview of the fate that will befall the Liberal-Tories over the next couple of years.

In the meantime, the hit to confidence in the US, the impact on US growth, and on its debt rating, when the markets are considering the nature of the Bond Bubble, would have dramatic consequences.  A decision by a number of large Bond Funds to move out of US Treasuries - a similar fate could befall UK Gilts, as UK inflation rises, whilst growth once agin collapses, and Government Borrowing continues to rise to pay for the drop in Tax receipts and rise in welfare payments - would burst the massive bubble in sovereign bonds, and thereby bring about a sharp rise in interest rates.

The consequence of that in the UK was highlighted by the Resolution Foundation in its report on UK personal debt, and the threat to UK households from just a tiny rise in interest rates.  But, the same principle applies to the US.  The fate of the global economy remains on a knife edge, subject to the political decisions made by Governments.

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