Forget the Fiscal Cliff – There’s a Much Bigger Threat Out There

Happy New Year!

Broken any of your resolutions yet? If not, well done.

If so – well, never mind. You’re in good company.

With their last-minute deal on the ‘fiscal cliff‘, US politicians have proven yet again that government promises to cut spending are about as reliable as our own annual vows to do more press-ups, eat less cake, and stick to 21 units of alcohol a week.

It seems the ‘cliff’ was more of a speed bump than the precipice that everyone had dreaded. But what does the deal mean for your money?

We’ll be Back at the Fiscal Cliff Edge
in a Couple of Months
 

Cast your minds back to August 2011. That summer, the US lost its AAA credit rating. Why? Because politicians couldn’t agree on what to do about the country’s huge debt pile.

Back then, the Democrats and the Republicans were squabbling over raising the federal debt ceiling above $14.5trn. The debt ceiling is a completely arbitrary legal ceiling on the amount of money the US government can borrow.

When it was first introduced, the idea was that it would act as some sort of break on government spending. Instead, it’s simply been raised every time a government has decided it wants to spend more.

On this occasion, however, the conflict was more bitter. The ceiling was raised, but only after both sides agreed to a package of automatic spending cuts that would come in from 2 January 2013 – i.e. today – unless politicians agreed on an alternative deal. On top of that, ‘temporary’ tax cuts introduced by George W Bush were also set to expire at almost the same time.

So Americans would be paying more tax, while government spending would be slashed. That promised to be a painful dose of austerity, which many believed would send the economy tumbling back into recession.

Understandably, markets were nervous about such an outcome. That’s why they’ve all shot up this morning after a deal was reached last night in the US.

But what’s the deal?

So far, the Bush-era tax cuts have been kept for everyone except Americans who earn more than $400,000 a year (or $450,000 for families). Meanwhile, the automatic budget cuts have been delayed for at least two months.

In other words, they’ve ‘kicked the can down the road’ yet again. Given that the point of all this panic was to cut spending, it’s hardly an impressive outcome. Various proposals floating around until now had looked at ways to cut between $2trn and $4trn over ten years from the national debt. As it stands, this ‘fiscal cliff’ deal will actually add $4trn to US debt over ten years.

Amusingly enough, it also means that in just two months’ time, America’s politicians will find themselves back where they were in August 2011. They’ll be squabbling over whether to raise the debt ceiling, and how to cut spending. Only this time, the national debt will be up at $16.4trn, not $14.5trn.

This is the problem. As Reuters points out, the fiscal cliff is now turning into more of a mountain range to be navigated. Once the February deadline is passed, there are other deadlines in March. And at each of these turning points, Republicans will be calling for spending cuts, and Democrats will be looking for tax hikes.

It’s not quite as bad as the rolling crises we’ve seen in the eurozone over the past few years, but there’s more than enough potential drama to keep markets on their toes over the coming months. That means you can expect plenty of noise and artificial panic and headline-grabbing on this topic between now and March at least.

Forget the Day-to-Day Drama –
the End-Game is Inflation
 

As an investor, you need to take a step back from all this. What have we learned from Europe, or even the UK’s own attempts to cut? It’s that when push comes to shove, politicians would rather not take the hard choices.

The path of least resistance is the inflationary path. That means loose monetary policy – which we already have almost everywhere – and loose fiscal policy, where possible. Like everywhere else, the US would much rather inflate its way out of trouble, rather than repay its debts or live more within its means.

So you can expect deals to be reached every time the politicians meet up. Even if it means the fiscal cliff face just keeps being shunted further off into the future.

John Stepek
Editor, MoneyWeek

Publisher’s Note: This is an edited version of an article that originally appeared in MoneyWeek

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