The U.S. election hadn’t even been over for 12 hours before the financial markets turned their attention from the election results (where not much changed) directly to the fiscal cliff.

About to fall off the fiscal cliff?

This week I saw one of the financial TV stations actually showing a clock counting down the days, hours, and minutes until the imminent fiscal cliff. If you lived in the States you get the impression that on January 1, 2013 (Day 1 of fiscal cliff armageddon), we may wake up without power or running water. But before we arrive at that conclusion, let’s take a step back.

 

Take a step back: what is the fiscal cliff?

The fiscal cliff is the term Ben Bernanke gave to the coincidental impacts of:

  1. the scheduled increase in tax rates partly related to the expiration of the Bush-era tax rates;
  2. spending cuts tied to the automatic $1.2 trillion in cuts over 10 years spread out over defence and non-defence spending.

Year one of these cuts is 2013. The projected magnitude of both the taxes and spending cuts is enormous.

Tax Rates

When President Bush passed the reduction in marginal tax rates back in the early 2000s, making them temporary was one of the concessions he made to get the bill through Congress. In 2010, President Obama and Congress agreed to extend these rates for an additional two years when they were originally set to expire because both parties ultimately agreed that the economic recovery was still too weak to allow an increase in marginal tax rates.

Spending

One of the resolutions of the August 2011 debt negotiations called for the creation of the Joint Select Committee on Deficit Reduction, charged with putting a plan forward by November 2011 that would find approximately $900 billion in federal spending cuts over the next 10 years. If the committee was unable to reach an agreement, the plan called for very drastic cuts of $1.2 trillion over 10 years. Guess what?  They couldn’t agree on a plan, so here we are today.

How will this be resolved?

This is the trillion dollar questions. Most analysts believe that these issues will be addressed. With the unemployment rate near 8% and the U.S. economy (GDP) growing at around 2%, it’s hard to imagine that elected officials from either side of the aisle will allow either or both issues to move completely over the fiscal cliff.

Regarding taxes, President Obama was pretty clear during his re-election campaign in expressing his desire to raise rates on individuals making over $250,000, while letting the rates that apply below that threshold remain at 2012 levels.

It’s hard to imagine we will see any meaningful tax reform between now and the first quarter of 2013.

As for the spending side, it seems that most agree that the indiscriminate cuts scheduled to begin in 2013 seem pretty stark. The kamikaze approach doesn’t even address one of the three largest national expenditures – Social Security. The agreement on spending cuts will likely be less than the $100 billion being planned for 2013, but will show some real cuts with agreed upon reforms that increase through the years that both sides can agree on.

What next?

An agreement that changes the trajectory of the growth in the US’s deficit could be very empowering for the U.S. and global economies. That being said, the current focus on the fiscal cliff is very reminiscent of the debt debate from the summer of 2011. Remember the noise level during that discussion? The market reacted negatively leading up to the resolution – but then it moved on.

While we have no way of knowing what the future holds, we can anticipate continued market volatility during the negotiations and when (or if) the fiscal cliff is resolved, the market will absorb the results and our attention will be drawn to the next “story” of the day.

 

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