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What is the “Fiscal Cliff”?

Date : 05/05/2012
Author:  Rajesh Dheenathayalan

The term “fiscal cliff” refers to a series of fiscal events set to unfold in U.S. at the end of this year and in early 2013. These include:
  • Expiration of the Bush-era tax cuts at the end of 2012, including current lower tax rates on capital gains, dividends, income, and estates, as well as number of other measures.
  • Expiration of fiscal stimulus measures, such as a 2-percentage-point cut in Social Security payroll taxes and extended unemployment benefits.
  • Spending cuts of $ 1 trillion over 10 years – which Congress approved during the Republican-led standoff over raising the federal debt ceiling in 2011 – will start kicking at the beginning of 2013.
 
Without a broad consensus among Republican and Democrat lawmakers to ensure the required Congressional action before the end of this December, up to $600 billion of expiring tax cuts, the levy of new taxes and automatic spending cuts to the tune of $ 200 billion are set to take effect at the beginning of 2013. That’s equal to about four percent of US GDP, which is likely to plunge US economy into a recession. The expected immediate collapse of financial markets due to these fiscal measures is coined as “Fiscal Cliff”.
 
It’s a double-edged sword. If the US government rolls back all expiring tax-cuts and implement spending cuts, it will be able to address both short and medium-term deficit problems - debt held by the public will fall to only 58 percent of GDP by 2022, below the 60 percent mark that many economists warn against exceeding. However, it will also result in a weakened economy that may fall into a recession, and unemployment will spike up to 9.1 percent from its current level of 7.9 percent. On the other hand, if all policies, including the payroll tax cuts, are extended, the economy will grow 2.4 percent but debt would also climb to 90 percent of GDP.
 
Therefore, the Congress and the White House need to work on a plan that uses a balanced approach. In the less likely scenario that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures, there would be major consequences for global financial markets.
 
A recession in the US economy, coupled with the sagging European economies and a slowdown in China’s growth could really hurt the world markets.
 
According to a recent Bank of America Merrill Lynch fund manager survey, nearly three-quarters (72 percent) of global investors believe that the fiscal cliff is not substantially priced into global equities and macroeconomic data. The fiscal cliff is identified as the number one tail risk by 42 per cent of respondents – up from 35 per cent in September and 26 per cent in August.
 
Markets have been working on the assumption that the U.S. is going to address the fiscal cliff challenge with a more gradual adjustment. Should a falling off the cliff really happen, the global stock markets would go in for a major correction.
 
For further reading, please follow the below link:
 

Tags:  US economy, US financial markets, US government

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