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Work and prosperity
1 January 2013

America's fiscal cliff – you ain't seen nothing yet

This post was written on the 31st December 2012 – the last day that America's politicians had to reach a deal on the so-called 'fiscal cliff'.

For reasons too complicated to go into even on the Deep End, a series of tax increases and spending cuts had been previously scheduled to automatically come into effect for 2013. With the economy in a fragile state, the general consensus was that a more gentle descent would be a good idea.

However, Democrats and Republicans have been unable to agree on the balance between tax increases and spending reductions in a modified budget, resulting in deadlock.

By the time you read this, a deal may have been agreed. But whatever happens, the economist Simon Johnson is unlikely to be impressed. Writing for the New York Times, he takes a look at the numbers bandied about by the politicians and finds them inadequate to the task of timely deficit reduction.

  • "If we want to start putting federal government debt on a more sustainable path, we should find a path to fiscal adjustment that undoes the net effect on the budget of the George W. Bush-era tax cuts, which represent about $4 trillion over the next 10 years. You can do that through revenue or through spending reductions, but that is the right goal to aim for…
  • "Such a change would put government debt on track to stabilize around 40 to 50 percent of gross domestic product by 2030 – an entirely reasonable and responsible goal." 

The good news is that America, "in contrast to many parts of Europe", still has time to phase in the necessary adjustments. Nevertheless, Johnson argues, now is the time to put the long-term fiscal strategy firmly into place:

  • "About half of all federal government debt outstanding is held by foreigners. Sooner or later, foreigners will want to buy less United States debt. Either they will want to hold other assets – the fashion in currencies comes and goes over time, just like everything else – or they will save less (in which case they may hold onto their existing United States government debt but not want to buy so much of new issues)."

Crucially a major part of that debt is held by the Chinese government – a sum of more that $1 trillion. Just how much more isn't clear, but whatever the true figure it is "far more than China needs." No one is suggesting that Beijing is about to foreclose on America, but it doesn't have to. Until America sorts out its deficit, all that its main creditors have to do to trigger a crisis is not buy as many US bonds as they used to:

  • "No American politician wants to talk in public about what the implications of shifts in China’s savings and investments would be on our ability to finance federal government debt at reasonable interest rates. The middle class will pay more tax or receive fewer benefits, or both, over the coming decades – that’s the inconvenient math of the Congressional Budget Office. Which politician wants to level with voters on the scale of this issue?"

Whether avoided or not, the fiscal cliff may turn out to be a pothole compared to what awaits America at the end of the road.



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