Commentary: Why the US Won't Go off the Fiscal Cliff

Since the US presidential elections earlier this month, markets have been under considerable downward pressure over fears of the fiscal cliff.  Equity markets are posting red across the board.  The Dow Jones has experienced several 200+ point sell offs in the recent sessions.  On Fx, markets are expressing the general risk off mood by running to 'safe haven' assets like the USD and JPY, while selling off riskier currencies such as MXN, TRY and ZAR.  AUD and CAD have shown some resilience, but both are off their highs.  AUD is objectively the most 'respectable' high yielding currency.  Australia is the only advanced economy whose central bank is not implementing very low interest rate policies.  

The fiscal cliff undoubtedly presents the greatest macro-economic risk to the global recovery, and policy makers in Washington would do well to craft an agreement as quickly as possible to calm jittery markets.  The going off the cliff would tighten fiscal policy by cutting the deficit by roughly 800 billion.  This would be achieved by spending cuts and the repeal of all the Bush tax cuts.  Currently, the deficit is roughly 1.2 trillion; an unprecedented sum for an unprecedented slowdown.  Those concerned about the fiscal cliff are falling back on the economic dogma developed by John Maynard Keynes in the 1930s, which established that in the short run, the amount of production in the economy equaled the amount of spending in the economy.  A crucial part of that spending is deficit spending by government.  

The obvious plan is to allow fiscal policy to tighten slowly over time so that the consumer and investors can pick up the slack as the government deficit falls.  This may call for say 50 to 100 billion is deficit reduction for 2013, with more reductions throughout the decade as the recovery takes hold.  The composition of this reduction, ie, how much is achieved through cuts and how through tax increases is probably largely irrelevant, and Obama knows it.  100 billion dollars in a 15 trillion dollar economy is just not that big a deal, even with Keynesian multipliers.  Obama will push for tax increases on the rich in order to achieve a post election political victory.  To me, this seems a waste of hard won political capital, since again the total deficit reduction only should be about 100 billion at max, and the Bush tax cuts for top earners (250,000k+) is only 80 billion a year.  A much more significant longterm policy achievement would be to reform immigration or pass the Dream Act.  Both would spur growth by removing artificial barriers to the movement of human capital.  

Thankfully, there are many vested interests who want to maintain the status quo.  This includes voters who will not willingly accept that their taxes should go up, as when as innumerable industries which rely on government contracts.  When all is said and down, the groups that experience the most pain when the deal is struck later this year will be those groups with the least clout in Washington and the least organized lobbying efforts.