Why the Fiscal Cliff might just be good news

Here’s a thought: what if the fiscal cliff America is about to tumble over is just what the doctor ordered?

With only a few days left before the end of the year, it looks increasingly likely that the US will indeed go over the so-called cliff. What this means in practice is that, for a period at least, tax rates will rise, as a number of previous temporary tax cuts – most notably those imposed by George W Bush – expire. And, gradually, government spending will decrease, with most of the brunt borne by defence spending.

Although in reality the fiscal contraction is more of a slope than a cliff – particularly in terms of the spending cuts – it’s nonetheless more aggressive than normal tax and spending measures. And far more abrupt than the more gradual fiscal tightening in the UK. To take one example, as of January, the lowest income tax rate will rise, overnight, from 10% to 15%. The highest rate will rise from 35% to just under 40%.

The Congressional Budget Office reckons that if the US does indeed go over the cliff it will slide back into recession, with the economy shrinking by 2.9% in the first half of 2013, and the unemployment rate, currently under 8%, climbing to 9.1%. And there would be knock-on effects for everyone else too: all countries would suffer if the world’s largest economy suddenly shrank. And don’t forget that most international forecasters, including the International Monetary Fund, were assuming that the US would come up with a fix for the cliff: so they will all have to downgrade their forecasts too.

But here’s the thing: the US needs at some point to confront its debt problem. At the moment, America’s annual deficit is around the same size as Britain’s: according to the IMF both the US and UK will borrow an amount worth 7.3% of their respective economic output next year. However, Britain’s deficit will come down to 1.7% of GDP by 2017 while America’s will only come down to 4.4% in that period.

Almost every economist agrees that at some point the US needs to bring its deficit back under control – though they differ on timings and methods. But let’s say you wanted to try to keep the country’s total public sector debt, which is currently 90% of GDP, below 100%. According to Charles Dumas of Lombard Street Research, that would involve a fiscal contraction (eg a combination of spending cuts and tax rises) of around 4-5%.

And if you were a politician, you would probably want to get most of that pain out of the way as soon as possible after an election. Step forward the fiscal cliff: a ready-made 5% fiscal contraction set to come into force in the coming week, hot on the heels of the last Presidential election.

The point is that although no-one really intended for the fiscal cliff actually to come into force – it was designed, back in 2011, as an incentive to persuade the Republicans and Democrats to come up with a more palatable set of fiscal measures – it is in many ways what a rational politician might have designed. Moreover, it comes into effect just as the US economy is showing genuine signs of recovery: car sales are up to the highest level since the slump, shale gas promises to boost the country’s energy prospects and overall economic output looks pretty solid.

None of this would prevent the economy from facing that recession the CBO has predicted. But Dumas suggests that a fiscal cliff of some sort would leave the US even better placed to bounce back towards the end of 2013 – without those concerns that its enormous debts will go on rising forever.

Now, clearly it would be preferable for the politicians to negotiate something less aggressive than the cliff in its current state – Dumas reckons 2% of GDP or a little more. And the best bet is that they will indeed come up with some kind of compromise to lessen the blow – though that won’t prevent them going over the cliff for at least a period.

That’s right – it’s quite possible to go over the cliff for a while and then come back to normality again. It’s still possible this could be more of a fiscal bungee jump than a freefall.

The real deadline is, once again, the debt ceiling which legally prevents the Administration from borrowing beyond a certain amount in cash terms. After some last-minute fiddles from the Treasury, the US will be due to exceed its debt ceiling sometime in late February or early March. That’s the real crunch moment – when the Federal government might have to face shut-down. So expect the horse-trading to continue for some time – maybe even all the way until then.