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From One Fiscal Cliff to the Next

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America is engrossed in political spectacle while politicians play fiscal Russian roulette. The battle for the presidency has become tense and the U.S. economy could be about to jump off a fiscal cliff on January 1, 2013. Next year there will most likely be another fiscal cliff.

Divided Washington

Notwithstanding all the excitement and suspense generated by debates and poll results, odds are still in favor of Obama. The House of Representatives will remain in Republican hands. When it comes to the Senate, Democrats will keep the upper hand, albeit by an even smaller margin. Therefore, we will see at least two more years of a deeply divided Washington.

Regardless of political deadlock, Washington needs to take weighty decisions before the year is out. The lame-duck Congress will have until December 31st to fend off the fiscal cliff. The latter means that, if Congress does nothing, various taxes will be raised on January 1st. Automatically, around $500-600 billion worth of cutbacks (in defense and domestic programs) will be implemented for a period of 10 years -- to start with $55bn in 2013. These tax hikes and spending cuts will translate into a reduction in economic growth of 3 percent- 5 percent of GDP.

Political Games

The belief is that Congress will be more prepared to water down the wine during a lame duck session than when circumstances revert to "normal." However, this is not always the case: in 2008 the outgoing Republican members of Congress filibustered an aid package for the automotive industry, which had been agreed between President Bush and the Democrats.

Some analysts believe the Democrats could be crazy enough to let the U.S. tumble off the fiscal cliff in a cynical attempt to resolve the tax conflict to their advantage. One of the biggest bones of contention between the parties is that the Republicans do not tolerate any tax rises at all whereas the Democrats want high earners to pay somewhat higher tax. If Democrats force the U.S. into the fiscal abyss, everyone will face higher taxes from January onwards. Subsequently, the Democrats can make a suggestion to lower taxes for the middle classes and the lowest paid. Should the GOP thwart this proposal, Democrats can make political gains if it paints the Republicans as "tax tormentors" who are out to "get" the middle classes.

Compromise Under Duress

Neither party will dare to go this far; not least because the markets are very nervous. Politicians are busily trying to find common ground. Old plans are being dusted off, including the Bowles-Simpson report and the Gang of Six initiative. These plans provided a fairly solid roadmap to fiscal responsibility. Eventually, lawmakers will probably undo many of the automatic spending cuts and extend most of the tax cuts that are due to expire. Even so, the political stalemate will probably make a dent in economic growth of 0.5 percent-1.0 percent over the course of 2013.

A deal will not provide a structural solution to the fiscal woes. At best we could see tentative steps towards healthier public finances and rough outlines for tax reforms, a restructured Medicare and Social Security, and spending cuts in other federal programs. However, it will probably prove impossible to prevent the creation of the next fiscal abyss, later in 2013, as "the can is kicked down the road" again.

The Next Fiscal Abyss

The U.S. cannot afford to kick that can for much longer. The baby boomers are reaching retirement age in droves and the population is aging. This puts a lot of pressure on Medicare and Social Security. In addition, doubts are rising about U.S. bonds. The situation will not get any easier now that many countries -- and some of the U.S. states -- are in dire fiscal straits.

In recent years, America has faced its largest budget deficits since 1946. Even if current tax cuts will unwind, if spending on health care is contained, and if existing plans to economize are implemented and adhered to -- for 10 years and over! -- deficits will still be considerable.

In other words, the problems in the U.S. will be far from over even if it manages to skirt round the fiscal cliff. Whoever becomes POTUS will have to deal with 2012's fiscal cliff as it morphs into 2013's fiscal precipice. The GOP may cultivate a reputation of fiscal conservatism, but it remains to be seen if Romney will pursue a sensible policy. He can only make good on his election promises if he raises middle class taxes. This he denies categorically. Not that Obama brandishes any detailed plans; his ideas of a U.S. economic revival continue to be vague. And, if the Tea Party pulls in many voters during the elections, there is the danger of an overly dogmatic Congress. This will not do the economy any good.

By next summer, or fall, we can expect the markets to become very jittery again as a deadlocked Washington once again faces the next fiscal cliff.