US teeters on a fiscal cliff edge

The world's biggest economy risks recession unless Congress acts swiftly. Stephen Foley reports from New York

Politicians might be about to voluntarily put the world's largest economy into a double-dip recession.

The US is headed for what economists are calling a "fiscal cliff" at the end of this year, when massive government spending cuts are due to kick in at the same time as a big jump in tax rates. Not since the end of US government war spending in 1945 has there been such a sudden slamming on of the economic brakes. Even the bipartisan Congressional Budget Office (CBO) is sounding the alarm. Unless Congress acts, it says, the barely-recovered US economy will go straight back into recession.

Even though analysts, political pundits and investors believe Congress will surely do something to prevent disaster, they also agree it might take the threat of a stock market meltdown to bounce it.

And it gets worse. The uncertainty and gathering risks are already crimping economic growth. That is bad news for the 12.7 million Americans who are out of work, and for global investors counting on the US to make up the slack from sickly Europe and slowing China.

"It is one of my biggest fears," says John Lonski, the chief US economist at Moody's. "How deeply will the financial markets have to fall to prompt the different interests in Washington into coming up with a sufficient resolution? We have seen this over and over again with budgetary stalemates. Agreement takes goading from Mr Market."

The fiscal cliff is the result of a coincidence of different factors. The first and largest is the expiry of president George W Bush's tax cuts, which were extended two years ago to stoke the nascent recovery, while the second is the expiry of a payroll tax cut for American workers, which is also a hangover from recession-fighting stimulus measures.

The third is the exhaustion of federal benefits to the long-term unemployed. The fourth and final factor is the budget deal that staved off a US debt default last summer, in which Tea Party Republicans showed their mettle and elicited a decade-long deficit reduction plan that begins with $65bn (£42bn) in spending cuts in 2013. All in all, the fiscal tightening could amount to $650bn next year, according to Barclays.

The uncertainty led Moody's to cut a quarter of 1 per cent from its growth forecast for the US economy this year, and the concern has reached the Federal Reserve, which also cut its forecasts last week.

"As we move forward in the year we do anticipate that the uncertainty associated with the so-called fiscal cliff will have some economic effects," Fed chairman Ben Bernanke said at the press conference which followed the central bank's monetary policy meeting on Wednesday.

"We heard anecdotes today in the meeting about firms that might be government contractors that were not sure about whether the contracts would still be in place come January and making employment decisions based on that. More generally financial markets don't like uncertainty and particularly uncertainty of this magnitude and I think that will be a negative."

The prospect of an early compromise seems remote now Congress has entered election season, when President Barack Obama plans to make the case for taxes on the wealthy, and his Republican challenger, Mitt Romney, left, will call for a sharp reduction in government spending. Hope is instead pinned on the "lame duck" session of the old Congress, after the elections but before new members take their seats in January.

A CBO report last month set out the stark consequences of Congress failing to find compromise before the end of the year. "Growth in real GDP in calendar year 2013 will be just 0.5 per cent, with the economy projected to contract at an annual rate of 1.3 per cent in the first half of the year and expand at an annual rate of 2.3 per cent in the second half.

"Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession."

Mr Lonski said that you have to go back more than half a century to find any parallels to the fiscal cliff.

"There was a great deal of worry in the 1940s, when people were anticipating the switch from wartime to peacetime spending levels, about whether the US economy would sink back into a depression. In that case, although there was a short recession, there were returning veterans forming families and there was pent-up consumer demand after rationing.

"Not so today. In fact, today it is possible that the private sector would suffer so much that it is overwhelmed and the overall drop in GDP is even larger. It is so ugly that it is difficult to contemplate."

Ajay Rajadhyaksha, the head of rates and securitised products at Barclays, said that forecasting the path of the US economy in the new year means "reading the political tea leaves" right now, and he has a worrying anecdote from a recent trip to Capitol Hill.

In two separate meetings with a senior figure from each party, he expressed his confidence that politicians will find agreement to mitigate the vast majority of the tax increases and some of the spending cuts. Both politicians responded the same way: "Republicans and Democrats are going to spend the next six months beating each other up. The last thing they are going to want to do after that is all hold hands."

In other words, don't count on Congress to do the right thing.