What we need is a higher fiscal cliff

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U.S. President Barack Obama: power limited

In two weeks, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered in the U.S. -- the so-called fiscal cliff.

Several temporary tax cuts will expire. The total amount involved is around US$500 billion through to September next year. Automatic spending cuts will also commence, totalling about US$600 billion per year and US$6.1 trillion over 10 years.

At least on the face of it, going off the cliff "improves" public finances, reducing the deficit and slowing the increase in debt levels -- America's debt mountain. But the automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about five per cent of GDP. In a recent report, the non-partisan Congressional Budget Office (CBO) estimated that the tax increases and spending cuts would reduce output by approximately three per cent and increase unemployment to 9.1 per cent by the end of 2012.

U.S. President Barack Obama's ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending. The most likely scenario is an incremental strategy.

A short-term compromise will be needed, involving extending some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.

Republicans might accept higher income taxes, particularly for those earning more than $1 million per year (rather than US$250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as a higher Medicare retirement age and changes to indexation of social security benefits for inflation. There would probably also be cuts in spending on defence and other social welfare programs such as Medicaid.

But the fiscal cliff will not of itself solve America's financial problems because it is simply not high enough.

What is needed is a radical overhaul of the tax system, including probably a value-added tax and wind-back of complex deductions and subsidies. What is also needed is a review of all spending, including defence and social welfare, to better target expenditure and align it with tax revenues.

But even with this action, without strong economic growth and decreases in unemployment, it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that "(very few policies) are large enough, by themselves, to accomplish a sizable portion of the deficit reduction necessary."

The U.S. will probably continue to spend more than it receives in taxes for the indefinite future, resulting in increases in U.S. government debt. This will force the Federal Reserve to continue existing policies, especially debt monetization by purchasing government bonds and the devaluation of the currency.

Given that the U.S. constitutes around 25 per cent of the global economy, it is unlikely America's problems will stay in America. If the U.S. takes the decisive action suggested, then U.S. growth will slow sharply in the short run, though the downturn may be shorter in duration and the longer term brighter. If the U.S. does not take decisive action, then U.S. growth will still be affected, though less significantly in the short run. But America's debt position will become increasingly problematic.

America's long-term growth prospects will also be adversely affected. Any slowdown in U.S. demand will affect its major trading partners such as China and Europe, exacerbating slowing growth and in turn affecting their trading partners.

U.S. dollar devaluation will create pressure for appreciation of other currencies, forcing other nations to implement measures such as zero-interest-rate policies, quantitative-easing programs or capital controls, to halt or at least slow the appreciation of their currencies to avoid reductions in competitiveness. Foreign investors in U.S. dollars and government bonds are likely to suffer losses.

How long the U.S. can continue its profligate ways is unknown. But as economist Herbert Stein observed: "If something cannot go on forever, it will stop."

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money and a consultant to Jory Capital.

Republished from the Winnipeg Free Press print edition December 26, 2012 B11