Next crisis: the debt ceiling

Next crisis: the debt ceiling

The early drama for financial markets this year has been served up in Washington.

The encouraging news is that President Barack Obama and Congress have avoided sending the American economy headlong over the so-called fiscal cliff, shorthand for $US600 billion of spending cuts and tax rises due to hit the world’s largest economy this month.

The House of Representatives on Wednesday (ADST) supported a deal that was voted for in the Senate the previous day, ensuring the US will escape the bulk of the measures that made up the cliff.

The Congressional Budget Office, a leading forecaster in Washington, had warned that if all the cuts and tax rises had come into effect - and stayed in effect - the US would slump back into recession for the first time since 2009.

Under the deal, the vast majority of Americans will be spared an increase in income tax that would have added an average of $US3500 to households’ tax bills, according to the Tax Policy Centre. Instead, only those earning more than $US450,000 a year will see their tax rate climb to 39.6 per cent from 35 per cent on any income above that level.

The last-ditch deal has also pushed back for two months the $US100 billion of cuts in government spending that were due. Emergency unemployment benefits, which also expired at the end of last year, will be extended under the deal. One economist summed up the results of 48 hours of frantic negotiation in Congress by saying ‘‘this keeps us out of recession’’.


But, while there was relief in Washington and across the US that the worst outcome had been avoided, there was also an acknowledgment that the deal will still represent a headwind for the US economy this year.

The unknown for Americans, and the rest of the watching world, is how big a headwind it will prove for a recovery that has so far failed to match the performance of recent economic rebounds.

Economists are most concerned by the decision not to renew an emergency cut in the so-called payroll tax, which both employers and employees pay. It was reduced from 6.2 per cent to 4.2 per cents at the beginning to 2011 in an effort to encourage companies to hire.

‘‘We continue to anticipate a significant economic slowdown at the start of the year in response to fiscal drag,’’ economists at Nomura argue. Michael Feroli, the chief US economist at JPMorgan, estimates that America’s economic expansion will now slow to a 1 per cent annual rate in the first three months of the year from the 3.1 per cent pace achieved during the third quarter.

What is clearer is that the protracted uncertainty over the fiscal cliff has damaged US consumer and business confidence. A survey last week showed consumer confidence dropping to its lowest for a year. Business investment had already slowed as companies awaited an outcome. As Americans return to work after the new year holiday, a second worry for the economy is that a large degree of uncertainty on fiscal policy remains even after this week’s deal.

The $US100 billion in government spending cuts, for example, have only been delayed two months. It is a timetable that is expected to coincide with a fresh battle between Republicans and Democrats on raising the government’s $US16.4 trillion debt ceiling.

Remember, Congress’s degree of dysfunction is unprecedented.

Mohamed El-Erian, Pimco chief executive

Amid the drama in Congress this week, it was barely noticed that the ceiling was hit on Monday and the US Treasury is now using emergency measures to help pay its bills over the next couple of months.

Economists at Bank of America believe the uncertainty that will come with a bitter battle over the debt ceiling is the biggest risk to the economy in the first quarter of the year.

A comfort is that the US economy starts 2013 with the labour market still gradually strengthening and the housing market poised to build on the signs of recovery that emerged in the second half of last year.

Investors already knew this was going to be the year America stepped up its austerity effort. The first few days of the new year have offered a reminder that the process will be a fractious one as Republicans and Democrats remain bitterly divided over how much of the burden should be shouldered by cuts in government spending and how much by tax increases.

‘‘Remember, Congress’s degree of dysfunction is unprecedented,’’ says Mohamed El-Erian, the chief executive of Pimco, the world’s largest bond investor. In 2011, ‘‘silly posturing over the debt ceiling created a home-made problem that almost derailed the country’s slow recovery’’.

It is a safe bet there will be more posturing over the next 12 months. But as Europe still struggles with its own crisis, the broader concern for those watching the US is the exact path it chooses between growth and debt reduction.

Most investors and business leaders would like to see the White House and Congress achieve a deal that puts America’s public finances on a sounder footing in the long term, but that shores up the recovery now.

Pulling it off will require America’s political leaders to show far more ambition and a greater willingness to compromise than has been evident in the opening days of this year.

The Telegraph, London

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