The A, B, C of the fiscal cliff and what it means for Canada

A spelling-book style guide

Last week, Maclean’s Nick Taylor-Vaisey dared to speak the truth about the “fiscal cliff.” Though the term has been dominating the headlines from the very moment the Ohio ballot count effectively consigned Mitt Romney to a footnote in history, many people—including many journalists—don’t have a firm grasp of what it is. The 30-word cursory explanations we read every day at the top of most news stories, he notes, “can’t possibly do much to spread economic literacy.” It was a very good point, and it inspired Econowatch to come up with the “A, B, C” guide to the fiscal cliff and what it means to Canada. Here it goes:

is for austerity. That’s essentially what the fiscal cliff and the debate around it are all about.

The so-called fiscal cliff is a package of tax hikes and broad-based spending cuts set to come into effect on January 1, 2013. They are part of the Budget Control Act of 2011, the compromise bill signed into law by President Obama in August 2011 that allowed Congress to overcome the political stalemate over raising the debt ceiling. Among other things, the BCA establishes that:

  • A host of temporary tax cuts approved by the Bush administration, along with a two percentage point cut in payroll taxes introduced under President Obama, will be allowed to expire. This means higher taxes for 90 per cent of Americans, according to the Congressional Budget Office. Middle-income households (those making between $40,000 and $64,000 a year) would see their take-home pay drop by nearly $2,000 a year, estimates the Tax Policy Centre, a think-tank based in Washington D.C.
  • Government expenditures will be slashed by by $1.2 trillion between 2013 and 2021, with the cuts to be evenly spread across those nine years. Around 1,000 government programs, equally split between civilian and defense accounts, would face automatic spending cuts or “sequestration” of between 7.6 and 9.6 per cent, except for Medicare—the national insurance program for seniors—which would face a two per cent cut.
  • Finally, Americans who’ve exhausted regular unemployment insurance would cease to receive so-called federal emergency unemployment insurance.

This massive combo of tax increases and spending reductions would shrink the U.S. budget deficit very quickly, but also likely send the economy back into recession. In April, the Congressional Budget Office forecast that:

  • By the end of fiscal year 2013 alone, the budget deficit would shrink to an estimated $641 billion, or four per cent of GDP, from $1.1 trillion, or 7.3 per cent of GDP, in 2012. By 2021 the deficit would be running at 0.6 per cent of GDP and total federal debt would be less that 60 per cent of GDP, down from nearly 73 per cent today.
  • At the same time, the double hit of tax hikes and expenditure cuts would knock out the economy, with GDP shrinking 0.5 per cent in fiscal 2013. Unemployment would climb back up to 9 per cent, from 7.9 per cent today. (Without the fiscal cliff, the economy would grow by 1.7 per cent, and the rate of Americans without a job hold steady at current levels.) The economy would then adjust “to a lower path for budget deficits,” says the CBO, and resume growing at a healthy rate of 4.3 per cent in 2014. Unemployment would dip under six per cent by the end of 2017.

The fiscal cliff, in other words, would cause some considerable short-term pain in a country that is just now showing signs of a real recovery from the Great Recession. At the same time, it would achieve a very important long-term objective: drastically resizing the overall amount the government owes (i.e. the federal debt. The deficit, by contrast, is the amount the government needs to borrow every year to bridge the gap between its revenue and its expenditures. Each deficit adds up to the stock of already existing government debt.).

Now, keeping public debt in check is a good idea because if the government borrows heavily for extended periods of time, its demand for credit tends to push up interest rates, which raises the costs of financing investment, ultimately sapping growth (not to mention that it makes it progressively more expensive for the government itself to borrow money). A slow economy, in turn, makes it difficult for the government to spend less than what comes in. If public debt continues to grow faster than GDP, government borrowing becomes unsustainable.

Rebalancing that ratio is a delicate act. Slash spending too much too quickly and you might send the economy into a tailspin: no matter how much you shrink the numerator (debt), the denominator (GDP) shrinks faster. Worry only about short-term growth and you’ll never get the budget under control. In the long run, you’ll hamper long-term growth, not to mention the risk of a full-blown credit crisis if the government’s creditors lose faith in its ability to repay them.

These, of course, are the two extremes on a spectrum of possible policy approaches. Most economists favour some mix in-between but politics—in Washington, as well as in Europe, keeps getting in the way.

What’s remarkable about the fiscal cliff is that it is just as unpalatable from an economic point of view as it is politically. These blanket measures are sure to upset just about every constituency in America. And no wonder, the BCA was only supposed to scare squabbling Democrats and Republicans into drafting a better law. But, alas, that hasn’t happened yet.

Most analysts and policymakers outside the U.S.—including the Harper government and Bank of Canada Governor Mark Carney—continue to say that they are confident Washington will hack it eventually, but the uncertainty around whether and how they’ll strike a deal has already taken a toll on Canada (see ‘C’).

is for Bernanke. The Federal Reserve chairman is the one responsible for coining the phrase—and creating quite a deal of confusion around what exactly it means. As I’ve written last week, “fiscal cliff” is quite the dramatic choice of wording. Naturally, this seems entirely appropriate to those who, like America’s central banker, are very concerned about the potential impact of those drastic measures. If, on the other hand, you believe that a shock therapy is exactly what the U.S. needs to gets its fiscal house in order, then “cliff” seems like a politically charged term aimed at scaremongering.

Others have criticized the term for suggesting that, come Jan. 1, the U.S. economy will suddenly find itself suspended in mid-air à la Wile E. Coyote before a cartoonish fall  into the abyss shortly thereafter. The impact of the tax hikes and spending cuts, note these analysts, would be felt only gradually. It would likely lead to recession, but not immediately: better to call it the “fiscal slope”.

In fact, argues Chad Stone, of the Center on Budget and Policy Priorities:

the slope would likely be relatively modest at first (and then much steeper if 2013 unfolds without a fiscal resolution). This means that if there is no agreement by January 1, policymakers will still have some (although limited) time to take steps to avoid the serious adverse economic consequences that the Congressional Budget Office (CBO) outlines in its recent analysis of what will happen if the expiring tax cuts and new spending cuts take effect on a permanent basis.

Congress would also have the power to change the law retroactively, erasing any effects of the initial implementation of these measures. The U.S. Treasury also has some leeway in cushioning the blow from tax increases and spending cuts next year (read more on that here).

is, of course, for Canada. What does the fiscal cliff mean to us? A lot. As Finance Minister Jim Flaherty put it rather bluntly last week: if the U.S. takes a dive, “the Canadian economy would follow shortly thereafter.”

TD estimates that the fiscal cliff would cause a drop in U.S. GDP of 3-4 percentage points (you’ll notice this estimate is more pessimistic than the CBO’s). In turn, this would wipe over one percentage point off Canada’s economic growth, writes the bank’s Dina Ignjatovic.

Right now, she notes, we are particularly vulnerable to any negative shocks south of the border. Canada’s economic recovery was led by consumer spending—our exports haven’t yet gone back to pre-recessionary levels—but Canadians are now reining in their household debt and that domestic engine of growth is running out of gas.

If Congress comes up with an alternative package of austerity measures, the impact on Canada would depend on the specific mix of tax hikes and spending cuts U.S. lawmakers would opt for. An emphasis on tax increases would shrink Americans’ disposable income and be bad news for Canadian exporters, writes Ignjatovic. Based on the proposals set forth by the Obama campaign and the noises coming from the Republican ranks after the election, both TD and CIBS estimate that the hit to Canadian economic growth will be about 0.5-0.7 percentage points, leaving the country on track for two per cent growth in 2013.

But the way in which the U.S. deals with the fiscal cliff will also affect investors’ and consumers’ perceptions, whose impact on the economy is much more difficult to predict and quantify, former BOC governor David Dodge told the CBC on Sunday. In fact, uncertainty about Washington’s ability to solve the impending crisis—along with the Eurozone’s troubles and concerns about the slowing Chinese economy—have already dampened business sentiment in Canada and across the world. “Firms are generally more circumspect about near-term investment decisions and are focusing on minimizing costs,” the Bank of Canada notes in its Autumn Business Outlook Survey.

So how bad can it get for Canada? Dodge seemed optimistic. The Canadian economy, he noted, has a number of built-in “automatic stabilizers” that would soften the punch: when income levels dip, for example, so do tax rates to a certain degree; when unemployment spikes up, insurance payments rise as well.

And, should the blow knock the Canadian economy off its feet, there would be ways for the government to try and revive it with ad-hoc measures. Flaherty has repeatedly said Ottawa stands ready to inject more stimulus into the economy should the country “slip deep into a recession with high unemployment.” Carney, for his part, said he’s ready to loosen monetary policy again.

In sum, as Dodge put it last weekend, the road ahead is bound to be bumpy, but it’ll likely be a question of “potholes,” not “craters.”

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