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Will the U.S. Pull us All Over its Fiscal Cliff?

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It's coming, and it's big. The U.S. economy is careening toward the so-called fiscal cliff at a frightening pace, and it's creating a lot of concern. With the election now decided, will legislators seal a deal that allays these fears, or will political sclerosis drive America -- and the world -- to the precipice?

If it did, it would be a shame. Consumers -- 70 per cent of the U.S. economy -- are spending at a rapid clip while simultaneously mending their personal finances. Housing markets have turned the corner -- residential construction is up 35 per cent, and yet has a long way to go before it hits normal levels. Even shattered U.S. consumer confidence seems to be on the mend. At the same time, corporate America is in great shape: profits are near an all-time high, and businesses are sitting on a $5.7-trillion mountain of cash and near-cash. Is the present whiff of recovery incentive for action?

Under current U.S. law, previously delayed spending reductions will kick in early in 2013. Together with tax cuts that are set to expire on December 31, 2012, the spending resets would slap the U.S. with a fiscal tightening equivalent to a massive 5.1 per cent of GDP -- enough to plunge the American economy into a second severe recession in a matter of weeks.

Little could be done ahead of the November 6 election. As such, frantic deal making and negotiations have commenced, and are likely to intensify through the dying days of 2012. Will they succeed? The U.S. Constitution establishes checks and balances with the intention of limiting the power of any one branch of government, in essence, forcing brinksmanship, compromise and deal making. These types of debates, though rancorous, are an historic feature of the U.S. legislative process, although they have not prevented the current administration from passing tough, contentious legislation.

In fact, the legislation needed to address most parts of the fiscal cliff will be far easier to pass than the highly charged medicare and financial bailout bills, as there is broad, bipartisan agreement on details. Reductions in payroll taxes and tax cuts for the middle class enjoy broad support, while both parties would be loath to make deep cuts to defence.

Proper assessment of the likely impact of the fiscal cliff requires examination of each component of the forthcoming tax increases and spending cuts and assumptions about expected agreements and compromises. This leads to a projected fiscal tightening amounting to just 1.4 per cent of GDP. CBO output multipliers suggest a total economic impact worth 1.5 percentage points of U.S. GDP.

Given economic momentum, this fiscal drag will hit an economy that's sporting underlying growth of 4.3 per cent. Netting out the 1.5 per cent fiscal impact still leaves a 2.8 per cent economy -- true, not terribly exciting, but the underlying strength is -- and that's the part of the U.S. economy where most Canadian exporters are doing business. As the global economy's true powerhouse pulls it toward a real and lasting recovery, Canadian exporters should prepare to harness the new growth.

The bottom line? Concern about the potentially devastating impact of a full U.S. fiscal cliff is well-placed. That fear is the very catalyst that will keep legislators -- none of whom wants their name on the U.S. or global economy's epitaph -- at the table hammering out a workable and practical deal.

What The GOP Doesn't Want You To Know About The Deficit
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