News in Charts: Stepping back from the edge of the fiscal cliff

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US politicians backed a bipartisan agreement ensuring that the world’s largest economy will avoid the most significant downside risks associated with the so-called ‘fiscal cliff’. Markets reacted with initial optimism to the deal, perhaps more out of relief than anything else, but investor caution is warranted as further battles lie ahead. Politicians delayed for two months any decision over scheduled spending cuts, raising the prospect of fresh partisan disagreement at the end of February – just as the Treasury Department will require an increase in its statutory debt limit.

The most headline-grabbing announcement was that the ‘Bush tax cuts’ will become permanent for all but the highest earners, protecting over 98% of workers from the prospect of higher income tax rates. US President, Barack Obama, trumpeted the fact that middle income families ‘will not see their income taxes go up’. While this is technically correct, it understates the negative impact the vast majority of workers will face from other tax measures.

Under the deal, the wealthiest Americans will indeed bear the brunt of increased taxation; however, a temporary payroll tax cut has been allowed to expire, pushing that rate up from 4.2% to 6.2%. This move will raise around $130bn this year, and affect households across the income scale. The median household, earning $50k pa, will see its disposable income fall by more than 2%, putting significant downward pressure on consumption.

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Conspicuously absent was any agreement on the spending side of the equation. Leaders postponed $111bn in cuts for up to two months, raising the prospect of further uncertainty and partisan bickering in the weeks ahead. Overall, the agreed package implies fiscal consolidation next year of just over 1% of GDP, or roughly a quarter of the ‘fiscal cliff’, with the risk of further drag from spending cuts, depending on how negotiations play out over the coming weeks.

Equity markets’ initial reaction to the news was positive, presumably because a major downside risk has been taken off the table. In our view, however, that risk was always an extremely low probability event. It never seemed likely that policymakers would shoot themselves in the foot by allowing the ‘fiscal cliff’ to be implemented in full. Nevertheless, markets had fallen as the New Year deadline approached, and the rally was perhaps an unwinding of this more than anything else.

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It is also worth noting that the legislation passed earlier this week did almost nothing to put the US fiscal position on a sustainable path. According to the IMF, the US government’s structural balance amounted to -6.8% of GDP last year. The agreed upon deal will only reduce this number by around one percentage point, leaving a substantial gap still to be filled – either through increased revenue or decreased spending. Neither option is likely to garner widespread public support.

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We find it hard to be anything but disappointed by the last-minute deal. What we saw was far from the grand bargain of delayed austerity, in exchange for a coherent plan for fiscal consolidation, that some had hoped for. Instead, we got a last-minute compromise – a European-style ‘kicking of the can further down the road’ that merely postpones the point at which difficult decisions will need to be taken.
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