Congress may kick the fiscal can off its cliff

AS WE rumble towards 31 December, US policymakers seem to be doing little of substance to address America’s looming fiscal cliff. And unless making speeches about the problem is going to make it go away, it is highly likely that we will see the kind of market uncertainty that we last witnessed in the summer of 2011, when Congress was deadlocked over the US debt ceiling.

The fiscal cliff refers to the effects of a raft of laws and changes to the tax system that kick in from 31 December. Among them, the Budget Act of 2011 requires the President and Congress to agree to a nine year, $1.2 trillion (£750bn) deficit reduction programme, or cuts to defence and non-entitlement outlays of $54.7bn. At the same time, Bush-era tax cuts, including the 2 per cent payroll tax holiday, will expire and new taxes relating to President Barack Obama’s health care laws will come into effect. With the US federal budget deficit running in excess of $1.17 trillion – a gross debt to GDP ratio of 104 per cent – the US Treasury will struggle to handle the 3.5 per cent drag on GDP that this slew of measures is forecast to create.

With a month and a half left until this deadline (less if you allow time for a plan to be tabled and debated), there are three possible routes that Congress may take. The first is to simply let the measures, as they currently stand, go into force. This would have the benefit of slicing the US deficit in half. But the risks of a recession triggered by job-killing tax hikes may be bigger odds than policymakers are willing to play with. The second option is for policymakers to cancel some or all of the tax increases and the spending cuts. This may avoid the drag on GDP, but it would increase the monstrous US deficit and push America further into debt – not so much kicking the can along the road as kicking the can off the cliff.

The third, and most likely response to the fiscal cliff is for Republicans in the House of Representatives to concede to Democrat demands for increased taxes on high income earners by $100bn to $150bn. In exchange, Democrats will back curbs in spending by an equal amount.

Politics will usually follow the line of least resistance, and this tax and cut response is just that – giving a concession to politicians on both signs of the fence that they can parade in front of the party faithful as a sign that they sometimes live up to some of their promises. But the fiscal cliff bickering detracts from the reality. To mix geographic metaphors, the fiscal cliff is just the tip of the iceberg.

The US national debt that falls under the radar of the congressional debt limit stands at over $16.05 trillion. If Congress allows the spending cuts in the Budget Act to kick in, it will halve the deficit. But that still equates to more than $500bn being added to the US debt every year. And with the US debt limit currently set at $16.4 trillion, Congress is heading towards another debt ceiling stand off. At its current rate, the US will hit the ceiling by January 2013 – meaning that no sooner will it have responded to the fiscal cliff than it will face another bitter, drawn out, market destabilising battle over raising this ceiling again.

While all of this is bad news for America, a re-run of history spells good news for gold bulls.

When you have US fiscal uncertainty, monetary expansion from the Federal Reserve in the form of its open-ended quantitative easing programme (QE3), and capital controls in safe havens like Switzerland, gold is a buy.

Though it gets lumped in the commodity category, gold is more at home as a currency or as a stand-alone asset. Whereas commodity prices stand at the mercy of the laws of supply and demand, gold for the most part occupies a space away from the x and y axis.

Infinitely divisible, portable, and highly liquid, gold is seen as the ultimate haven asset. There is an estimated 170,000 tonnes of gold above the ground – less than the amount of steel produced each hour. There is little or no natural industrial demand and the majority of gold is in private hands. This means that, although 2,500 tonnes are mined each year, there is still a 65-year overhang in supply. As a result, gold is seen as a Giffen good – meaning that people paradoxically consume more of it as the price rises – violating the law of demand.

If the US starts to look shaky again, investors will become nervous and start shifting their holdings out of riskier assets like equities, corporate bonds and dollars and into the safety of the yellow metal.

Though it is down from its early October highs of almost $1,800 per ounce, gold has been trading near multi-week highs. For the moment, it is Fed chairman Ben Bernanke’s QE programme that is giving gold support. But as we head towards the fiscal cliff, and the potential debt ceiling aftermath, look for gold to be kicked back into action, thriving as the dollar suffers.