America’s Fiscal Cliff

The world is focused on the fiscal cliff, a term referring to the scheduled reductions in the US budget deficit, by way of expiring tax cuts and mandatory spending cuts. The fiscal cliff may ironically improve public finances, reducing the deficit and slowing the increase in debt levels –America’s debt mountain. But going over the fiscal cliff will not of itself solve America’s fundamental financial problems.

Successive US administrations have avoided dealing with the US debt problem. Policy makers have adopted the rulebook of rapper Tupac Shakur: “Reality is wrong. Dreams are for real”.

Debt Mountains…

US government debt currently totals around US$16 trillion. The US Treasury estimates that this debt will rise, in absence of corrective action, to around US$20 trillion by 2015, over 100% of America’s Gross Domestic Product (“GDP”).

There are also additional current and contingent commitments not explicitly included in the debt figures, such as US government support for Freddie Mac and Fannie Mae (known as government sponsored enterprises (GSEs)) of over US$5 trillion and unfunded obligations of over US$65 trillion for programs such as Medicare, Medicaid and Social Security. US State governments and municipalities have additional debt of around US$3 trillion.

US public finances deteriorated significantly over recent years.  In 2001, the Congressional Budget Office (“CBO”) forecast average annual surpluses of approximately US$850 billion from 2009–2012 allowing Washington to pay off everything it owed.

The surpluses never emerged as the US government has run large budget deficits of around US$1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defence spending (15%); non-defence spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%).

Despite growing concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments remains strong.

Innovative” monetary policy from the US Federal Reserve has allowed the government to increase its debt levels. Around 60-70% of US government bonds have been purchased by the Federal Reserve, as part of successive rounds of quantitative Easing (“QE”).

Federal Reserve action has been a key factor in keeping rates low, allowing the US to keep its interest bill manageable despite increases in debt levels. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying less than 0.10% per annum and 10 year bonds around 1.80% per annum.

But the current position is not sustainable.


In January 2013, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling allowing the government to continue to borrow.

Several temporary tax cuts will expire. The total amount involved is around US$500 billion through to September next year.

These include President George Bush’s tax cuts on income, investments, married couples, families with children and inheritances, which were extended for 2 years by President Barack Obama. In addition, the Alternative Minimum Tax (“AMT”) would commence, affecting up to 26-30 million middle-class Americans, increasing their tax bill by an average of US$3,700. The payroll-tax cut of 2% and extended unemployment benefits for the long term unemployed (both implemented by the Obama Administration to stimulate the economy) would also expire. A number of other smaller tax cuts for individuals and business (most notable tax credits for research and development and a deduction for state sales taxes) would also terminate.

Automatic spending cuts will also commence, totalling about US$600 billion per year and US$6.1 trillion over 10 years. The spending cuts would cover most government programs including cuts in defence spending and domestic programs. Medicare, the federal health programme for the elderly, would reduce payments including a sharp reduction (as much as 30%) in reimbursements to doctors.

The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about 5% of GDP.  In a recent Report, the non-partisan Congressional Budget Office (“CBO”) estimated that the tax increases and spending cuts would reduce output by approximately 3% and increase unemployment to 9.1% by the end of 2012.

Corrective Services

Bringing US public finances under control requires bringing budget deficits down, through spending cuts, tax increases or a mixture. The fiscal cliff is merely a step down that long road.

The task is Herculean. Government revenues would need to increase by 20-30% or spending cut by a similar amount.

The US has a lower tax-to-GDP ratio (around 18%) than even much maligned Greece (around 20%). The tax-to-GDP in most developed countries is closer to 30%.

Given 45% of households do not pay tax (because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.

Large components of spending – defence, homeland security, social security, Medicare, Medicaid, (growing) interest payments- are difficult to control and also politically sensitive, making it difficult to reduce.

Reducing the budget deficit and debt may also mire the US economy in a prolonged recession.

In 2009, students at National Defence University in Washington, DC, “war gamed” possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending.

The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.

As one participant in the National Defence University economic war game observed about the process of bringing US public finances under control: “You’ll never get re-elected and you may do more harm than good”.

Political Debt Dancing…

A decision does not have to be reached by the end of 2012. The US Treasury can juggle its finances to purchase time till perhaps February 2013, especially if an agreement is likely. The major constraint is the need to increase the US Government’s borrowing cap or debt limit (currently US$16.4 trillion), which will be reached late in 2012 or early 2013.

Necessary reform of the tax system, especially a broadening of the tax base, and all spending, including social welfare programmes, is unlikely to be politically easy.

The re-elected President Obama’s ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending.

President Obama asserts that he has a mandate to reform the budget, especially increase taxes on wealthier Americans. Having lost the Presidential election and also having failed to make hoped for gains in Congressional elections, the Republicans are defensive.  The GOP position is complicated by its fractious internal politics. More conservative elements believe that the loss was due to a shift to centrist policies and a return to more strict conservatism is required.

Republican House Speaker John Boehner has appeared conciliatory, signalling a willingness to consider some higher taxes. In the fissiparous world of US politics, nothing is guaranteed, especially given the short electoral cycle. The prospects of a definitive grand bargain remain poor. The more likely scenario is an incremental strategy.

A short term compromise will be needed, entailing extensions of some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.

President Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1 million per annum (rather than US$250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as higher Medicare retirement age and changes to indexation of social security benefits for inflation. There would probably also be cuts in spending on defence and other social welfare programs such as Medicaid.

The fiscal cliff or the measures likely to be adopted may not to be enough to address the deep-seated problems of American public finances.

What is needed is a radical overhaul of the tax system, including probably a value added tax and wind back of complex deductions and subsidies. What is also needed is a review of all spending, including defence and social welfare, to better target expenditure and align it with tax revenues.

But even with this action, without strong economic growth and decreases in unemployment, it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that “[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary”.

Our Debt, Your Problem…

Given the magnitude of the challenge and the lack of political will, the US will continue to spend more than it receives in taxes for the indefinite future, resulting in increases in US government debt. This will force the Federal Reserve to continue existing policies, especially debt monetisation by purchasing government bonds and the devaluation of the currency.

Debt monetisation (printing money in popular parlance) will continue, entailing the US Federal Reserve purchasing government bonds in return for supplying reserves to the banking system.  Zero interest rates policy (“ZIRP”) in conjunction with debt monetisation will be used to devalue the US dollar.

Of the US gross government debt of US$16 trillion, the US government holds around 40% of the debt through the Federal Reserve, Social Security Trust Fund and other government trust funds. Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold 25%. Foreigner investors -China, Japan, oil exporting nations, Asian central banks and sovereign wealth funds- hold the remaining 35%.

Existing investors, like China, must now continue to purchase US dollars and government bonds to avoid a precipitous drop in the value of existing investments and to avoid a sharp rise in the value of their own currencies which would reduce export competitiveness.

Expedient in the short term, monetisation risks debasing the currency. Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened. On a trade weighted basis, the US dollar has lost around 20% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 35% against the Australian dollar and 20% against the Singapore dollar over the same period.

The weaker US dollar also allows the US to enhance its competitive position for exports; in effect the devaluation is a de facto cut in costs. This is designed to drive economic growth.

As the US dollar weakens it improves America’s external position. US foreign investments and overseas income gain in value. But the major benefit is in relation to debt owned by foreigners.

As almost of its government debt is denominated in US dollars, devaluation reduces the value of its outstanding debt. It forces existing foreign investors to keep rolling over debt to avoid realising currency losses on their investments. It encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt. As John Connally, US Treasury Secretary under President Nixon belligerently observed: “Our dollar, but your problem.

Debt 22…

Given that the US constitutes around 25% of global economy, it is unlikely America’s problems will stay in America. The rest of the global economy is literally tied to the US as it edges closer to the cliff.

If the US takes the decisive action suggested then US growth will slow sharply in the short run, though the downturn may be shorter in duration and the longer term brighter. If, as likely, the US does not take decisive action then US growth will still be affected, though less significantly in the short run. But America’s debt position will become increasingly problematic. America’s long term growth prospects will also be adversely affected.

Any slowdown in US demand will affect its major trading partners such as China and Europe, exacerbating slowing growth affecting their trading partners.

US dollar devaluation will create pressure for appreciation of other currencies. This may force other nations to implement measures, such as zero interest rate policies, QE programs or capital controls, to halt or at least slow the appreciation of their currencies to avoid reductions in competitiveness.

Foreign investors in US dollars and government bonds are likely to suffer losses. Large investors like China and Japan may suffer significant declines in the value of these assets, reducing their national savings.

In Hamlet, William Shakespeare’s tragic hero states that: “I must be cruel only to be kind; thus bad begins, and worse remains behind”. In trying to preserve its position, the US now is increasingly adopting toxic economic and financial policies, which have the potential to damage other nations and ultimately its own future.

Former French Finance Minister Valery Giscard d’Estaing used the term “exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate”.

Economist Herbert Stein observed: “If something cannot go on forever, it will stop”. How long the US can continue it profligate ways is unknown.

7 Responses to "America’s Fiscal Cliff"

  1. benleet   November 20, 2012 at 3:16 pm

    The election 2 years out, of 2014, will be crucial. A standoff will characterize the next two years. During the past 30 years the economy grew by over 68% per capita, between 1979 and 2007 its growth was exactly 68%. But the median household's income, 1979 to 2010, grew by only 7%, while the top 5% grew household income by 120%, the top 1% by 275%, and real wages over 40 years actually decreased. (See this web page for some details:
    Point: for most Americans growth disappeared, the wives added to the family income by about 13 weeks of income. We had a debt explosion in the private sector, not the public sector. But after the banks went bankrupt and were bailed out with taxpayer money, the mortgage holders and workers were left with large debts on over-valued homes, shrunken equity levels in their ownership, and declining opportunities. Between 2009-2010 93% of the economic growth went to the top 1% of households. This sort of inequality of rewards is the achilles heel of global development. The outcome will depend on public education in the next 2 years. I write a blog, The portion going to taxes in the U.S. is higher, 27% not 18%, for comparisons see

  2. David T. Nowakowski   November 21, 2012 at 8:27 am

    This blog post is so full of factual and logical errors that I can't hope to correct every one, but here is a starting list:
    Reagan, Bush I, and Clinton all dealt with the debt problem in meaningful if incomplete ways, before Bush II and the crisis got us here.

    US Marketable Debt is only $11 trillion, the other $5 trn is the Soc Sec "debt" which is not real. If you are considering Soc Sec along with unfunded obligations you shouldn't start with $16 trn because $5 trn of that funds Soc Sec out to the 2030 or so.

    Fed (i.e. the gov't itself) owns $1.6 trillion treasuries (and $0.85 trn MBS). So the privately held debt is really just $9.4 trillion, though the Fed also has liabilities (excess reserves) held against these assets.

    Saying 45% of households don't pay tax is Factually Wrong. Was your source Fox "News"? This is roughly the number for income tax, but only 15% or so of households don't pay any federal taxes, since payroll and other taxes hit everyone. And some of those not paying are unemployed or retired, so they do pay or have paid their fair share. (

    A radical overhaul, thanks, that is a great plan! Er, details welcomed…

    Foreigners largely stopped buying treasuries in 2008-9, but guess what — the USD strengthened and rates dropped! Since 2009, the crisis abated and the dollar weakened back to where it was before — where it should be, given the economy has been crippled by a deep recession. When the Fed ends QE3 in 2013 or 2014, and shale oil gets going, and the output gap closes — what do you think will happen then, to the dollar, to tax revenues, etc. The current situation is not set in stone, so Herb Stein's maxim doesn't apply. Anyway, US debt has previously been way above 100% of GDP, if that is even the right denominator/unit.

    I'm not Pollyanna, there are structural problems and the sooner we deal with them honestly the better. But get your facts right, first!

  3. rk_arya   November 23, 2012 at 6:46 am

    the fiscal cliff is very tedious problem as it demands the cut in spending and raising the taxes one way or the other. both the actions are extremely harmful to the US while it is coming out of recession. the growth and employment will be hampered and purchasing power will be reduced drastically. though the debt will stop to increease, but prolonged recession till the level of debt comes down to 60% at least, will not allow the US to improve growth. this amy take 4-5 years. the government has to cut down the import and export through devaluation of its own currency. once the dollar is devalued, the creditor would demand higher for repayment of the debt. since the entire transaction has been done in dollar, the currencies of the other countries would get automatically overvalued and hence stopping the export and investment all through other nations. it means the global growth would tumble. there should be one more round of currency meeting like the one in bretton wood system. where alll the currencies which are equivalent to the dollar in terms of trade and investment should come to occupy the place. the currencies of Japan, China and Switzerland are can play the prominet role.

  4. RKARYA   November 23, 2012 at 10:30 am

    fiscal cliff is going to be very tough for US economy. basically US fiscal deficit had to be kept very high to allow the economy to come out of recession through tax cut and spending. during the recession the economy indeed has responded to fiscal stimulus but its has cost the trillion of dollars as the debt from many other sources. there is fear of soverign down grading because the debt has almost reached 100% of GDP. in case US does not break the fiscal cliff , the down grading will create risk aversion among the investors. if it breaks the fiscal cliff, taxes will go up and spending cut would be severe which may create recession. how would US would like to solve the situation. as Fed has already decided to pump $ 40 billion every month against mortgaged securities, it may not solve the problem of fiscal deficit. but surely it would give little advantage to borrowers to utilise the funds where these are required. the only solution to solve the problem of debt is to go in for debt monetisation which in other words amount ot devaluation of the dollar against the six other currencies. in that case export are likely to go up but the emerging currencies will be overvalued against dollar. in that case export of emerging economies would suffer. india will take a hit of this decision, as roughly 25% export is likely to be affected. for the time being while europe is growing, the US export to europe would help to earn more than expected current account surplus. as current account surplus would substitute the fiscal deficit the problem of fiscal deficit would be solved to some extent. while Europe improves gradually, so is the US economy. meanwhile India will have to go insulate its currency from dollar and start accepting the currency of the trading partners. or the time is ripe to stop using the dollar as reserve currency for all the economies. to which China may not agree as there is now rebound in the chinese economy and the currency is also overvalued. India is now occupying a more fragile position in the worrld economy vis-a-vis the growth consideration.

  5. sherparick   November 24, 2012 at 1:43 pm

    So much bad in one column. I expect better from Economontior contributors.

    1. Promoting the meme that 45% of Americans don't pay "taxes." Apparently someone forgot to inform Mr. Das (or is it Professor Das) about what "FICA" means on his pay stub. This tax represents 40% of Federal Revenue and everybody who works pays it on the first $109,000 income in 2012 (but none above it). Also of course there are tariffs and excise taxes, and state and local taxes (mostly sales and property) that everyone pays, directly or indirectly.

    2. The U.S. has had a chronic current account deficit for 30 years, and particlularly for the last 15. In a floating exchange rate regime, without manipulation, this should not happen. The dollar should have fallen, although as "the reserve currency," it will probably be overvalued as long as it retains that status.

    3. If the goal is to restore private savings to 10% of GDP and balancing the Federal budget, then the current account must shift to surplus, which means that either a devaluation of the dollar or an internal devaluation of U.S. wages to cause increas exports and import substitution. Apolgists for Rentier Economics like Professor Das wants to accomplish this adjustment per internal devaluation through a decade long depression and double digit unemeployment rates as well as throwing social insurance programs out the windows.

    Professor Das needs to back and look at his Economics 101 text book.

    "To understand the principle involved, let’s suppose that at the current level of national income and employment the current account is in balance; ie, (X-M) = 0. Let’s assume too that there’s a private sector savings surplus of 10 units, or (S-I) = 10. Substituting into the above, the ‘government balance’ must be negative, or (T-G) = -10. If the private savings balance increases to 15, ceteris paribus the government balance or ‘the deficit’ must also widen to -15; this is precisely what happens when firms and households try to rebuild their savings after over-leveraging. But if simultaneously the external account improves by 5 units, or (X-M) = 5, the government account (T-G) can remain at -10."

  6. lkofenglish   November 25, 2012 at 4:23 pm

    at this point we are deal with the "simplicity of total incompetence" and hence can some up these complex issues thusly: "can they work out a deal or can't they?" the only reason we have elections in the first place is so that Representatives can come together and compromise on their alleged "beliefs" and agree on something. This "something" happens to be "in the existential interest of the Republic." i will be looking not for resolution but some agreement…and that will be it. If that cannot be achieved then in no way would i want to be long the US dollar…

  7. tm doud   November 27, 2012 at 6:15 pm

    You are an idiot!