There has been a lot of talk recently about the fiscal cliff. The discussion on this topic is only likely to increase now that the US election has been decided and 1 January 2013 gets closer.
The US houses of parliament have legislated maximum limits on the amount of debt that can be issued by the US government. If the limit is breached, the US goverment won't be ablt to pay any more bills including salaries of public servicants. This would be a serious issue for the US economy and its citizens.
On 4-5 occasions in the past 3 years the level of debt has approached the limit. Each time, the Rebublican party has pushed for reduced government spending while the democrats have wanted to delay the hard decisions and increase the limit. On each occasion, an 11th hour compromise has been reached.
The most recent agreement was reached in haste, within a few hours of the US government shutting down. The key points of the agreemement were that if a further agreement between the political parties couldn't be found, then drastic tax increases and spending cuts would kick in from 1 January 2013. The total impact on spending and taxes has been estimated at $500 billion per annum (3.5% of GDP).
When governments reduce spending and/or increase taxes, it sucks money out of the economy and tends to reduce economic growth and increase unemployment. Economists are suggesting this would quickly send the US economy into a deep recession.
What is the state of the US government finances?
The US government receives income of around $2.3 trillion p.a. and spends about $3.8 trillion p.a. So it running a deficit of $1.5 trillion each year. Or, to put it another way, its spending is 150% of its income. This is clearly not sustainable, and is the key reason why the total cumulative US government debt has grown to 100% of GDP (not far behind Greece and Italy, and more than Spain in percentage terms).
The government faces tough decisions. The 2 alternatives are:
Reducing spending and/or increasing taxes. This will slow the economy. They can't afford the economy to slow, unemployment is already at 8%.
Do nothing - This will ensure the country becomes insolvent in the long term - they will everntually end up in the same place as Europe with spiralling debt.
Neither results in a satisfactory outcome and these 2 alternatives will need to be carefully managed and balanced.
So what is likely to happen
Since the election result, the Dow Jones index market has fallen by 400 points (3%) over 2 sessions as the market now focuses on the fiscal cliff. This weakness could continue until the parties agree on a sensible long term plan. Neither party wants to show its hand too early, so a deal is unlikely to be reached until mid-late December. Stay tuned for further market volatility.
Please contact us to understand how this issue is likely to affect your investment portfolio.