Life on the edge of the fiscal cliff

Re-elected US President Barack Obama must plunge immediately into dealing with the problem known as the "fiscal cliff" - one of the three biggest challenges to face the world economy in coming months, according to The Economist.

The other two issues, for the record, are whether the eurozone crisis continues slowly to dissipate and how well the new Chinese leadership - due for installation in the days following the US election - handles slowing growth in China.

The source of the fiscal cliff problem is simple, its resolution less so. The administrations of both George W Bush and Barack Obama rushed stimulus measures into place in 2008 and 2009 to bolster the US economy after the global financial crisis.

As a result, some US$600 billion (NZ$727b) of tax cuts and spending increases are due to expire in January next year unless a new consensus can be reached among American legislators who, in recent times, have seemed unable to put national interest ahead of political ideology.

If consensus efforts fail, there is a chance that a mildly recovering US economy will fall back into recession, taking much of the world economy with it in 2013. New Zealand will not be immune.

Most worrying is the example provided by the mid-2011 deadlock over US federal debt ceilings, which saw the credit rating agency Standard & Poor's cut the US rating from AAA for the first time, blaming political unpredictability.

This time around, Moody's Investors Services - S&P's biggest competitor - is threatening to do the same if the US can't deal with the fiscal cliff. Pessimism on that score saw a posse of some of America's most powerful investors sign an open letter last month warning the consequences of failure would be "very grave".

"At a time when economic growth is less than 2 per cent, and with nearly 25 million Americans either out of work or underemployed, the still-fragile US economy cannot sustain - and the American people do not deserve - the impact of more gridlock in Washington," the letter from the Financial Services Forum said.

The letter may have lacked a certain moral authority, being signed by a group of American bank chief executives, whose institutions were at the heart of the reason for that fragility in the first place. But it reflects the fears of jittery market-watchers focusing on the January deadlines.

Part of the reason for nervousness is the large range of possible impacts from a deal that will be hammered out by political horse-trading, making nuanced policy-making virtually impossible.

As a result, it's unclear whether the big lessons learnt in the four years since the GFC hit will be capable of being applied to the fiscal cliff solution. It's clear, however, that policies which worked for the US in the 1990s to rein in its Budget deficits won't necessarily work this time.

In the 90s, the US private sector grew strongly, raising the tax take and offsetting the impacts of federal fiscal austerity.

Households were not only willing, but able, to borrow more. The US Federal Reserve was able to cut interest rates to stimulate demand.

None of those factors applies today. Interest rates are at zero, the Fed is getting less and less bang for its buck from money-printing, and households are repaying debt rather than taking it on anew.

Meanwhile, the International Monetary Fund has been recalibrating its earlier enthusiasm for fiscal austerity, warning that cutting spending or raising taxes too hard or quickly in this new, constrained environment can do excessive economic damage.

However, as a note from Wellington funds manager Harbour Asset Management, points out, an outcome in which the fiscal cliff turns out to be more stepping off the kerb than bungee-jumping into the abyss is possible.

Withdrawing every stimulus measure at once would be equivalent to a massive 4.4 per cent of US gross domestic product - a barely imaginable outcome which would spell recession.

Republicans and Democrats broadly agree that payroll tax cuts and unemployment insurance measures should end, with an impact equivalent to a far more manageable 0.8 per cent of GDP.

The biggest arguments will be in areas such as extending the Bush tax cuts for the wealthy, and automatic cuts to various elements of government spending.

"It is within this grey area that political pundits and economists are estimating scenarios for "plausible muddle through" and "plausible downside", which would cut from 1.5 per cent to nearly 2.5 per cent of GDP, says Harbour Asset.

The chances of plausibly muddling through are put at 50 per cent, while the harsher outcome prevailing is put at perhaps 35 per cent. Harbour Asset ranks the "over the cliff" scenario at just 5 per cent.

That's hardly a reason to be cheerful, but some optimism appears justified.

This story has been corrected to show the size of the US fiscal cliff at US$600 billion. An earlier version said US$600 million.