US politicians are facing the fiscal cliff

FOR months, the markets have had their eyes fixed on the Federal Reserve; the contents of the Federal Open Market Committee’s (FOMC) monthly minutes and the possibility of another round of quantitative easing (QE3). But now the US has another problem to deal with – the so-called “fiscal cliff” at the end of 2012, when the Budget Control Act of 2011 is scheduled to go into effect.

The act kicks in at midnight on 31 December. It brings in a slew of measures, including the end of the Bush-era tax cuts, the end of some business tax breaks, the end of last year’s temporary payroll tax cuts and the beginning of the taxes to finance President Obama’s health care laws. And with the US federal budget deficit running in excess of $1.17 trillion (£721bn) – 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 the perfect storm of measures will create.

We all remember the effect on global markets when the House of Representatives was deadlocked over the deficit ceiling. It is likely we could face similar tumult over the fiscal cliff.

Though most believe that a compromise can be agreed upon, what form that could take is the big talking point. Broadly speaking, there are three possible responses, though the window to achieve any of them before November’s presidential election has likely been missed.

The first possible outcome is that both Democrats and Republicans come to a clean and neat agreement that would trade Republican decreases in spending growth with increased Democrat taxes. But to have faith in this outcome requires a belief that both parties can work together to compromise in the midst of a bitterly fought election campaign.

A second outcome is that both parties could push for long-term extensions to their priorities. In the summer, both the Senate and the House came to compromises over various middle-income tax cuts. But a long-term compromise on the measures in the Budget Control Act would require an agreement on highly political issues like upper-income tax cuts, something that is unlikely to happen.

The third possibility is a short-term extension of current policies. The policy differences between the two parties – on defence spending and upper-income tax cuts – are worth around $100bn. It is unlikely that Congress would leave the US exposed to slipping into a technical recession over this, and a short-term extension of the majority of policies would save political face while averting a catastrophic fall off the cliff.

The result of the 6 November presidential election could bring a clear mandate for either side to bring about its policy priorities. But the closer that we get to the 31 December drop-off, the more edgy markets will become and the more the investor appetite for safety will increase.