The US fiscal cliff: on the edge

A last-minute deal to avoid recession is only a sticking plaster for a longer-term problem, reports Will Hodges

Chicago, 7 November 2012. It's a little after 2am and President Barack Obama has just delivered his victory speech at the end of a hard-fought re-election campaign. The president praised his Republican opponent, Mitt Romney, and said he was looking forward to sitting down with him to discuss how their two parties could work together to move the country forward. The president's speech hinted that he'd already turned his sights to the economic challenges facing the country over the weeks ahead.

Behind the scenes of the election campaign, the clock had been ticking. With tax cuts passed during George W. Bush's presidency due to expire on 31 December 2012, the Democrats and Republicans were tasked with reaching an agreement to bridge the fiscal cliff - the deadline after which $600 million (£370 million) in automatic tax increases and spending cuts would come into force to tackle the budget deficit. Without a deal, plunging over the cliff threatened to squeeze US GDP by 5 per cent, which would send the economy back into recession.

Tax hikes v. spending cuts

The first item on the president's agenda when he returned to the White House, therefore, was to negotiate a more gradual approach towards reducing the US budget deficit, which stood at $1.09 trillion in 2012. Obama and the Democrats hoped to protect middle class families and those on lower incomes from paying more tax by imposing higher tariffs on individuals earning $250,000 a year and above. The extra revenue gained from these increases would allow the government to balance the federal budget without needing to make severe cuts to social spending.

Meanwhile the Republicans, led by House of Representatives Speaker John Boehner, had been pushing for fewer increases in spending and taxes. They were willing to agree to income tax hikes only for the extremely wealthy - those earning $1 million and more. Slimmer tax revenues would be counterbalanced by cuts to federal spending on social security and free healthcare programmes for the poor and elderly.

A last-minute deal

By Christmas Day, with neither side willing to budge, the relationship between the two parties had turned increasingly hostile. Normally heralded for his gracious demeanour, Obama was accused by some members of the media of being petty and unnecessarily rude in his handling of the negotiations.

In the end, it took until the dying hours of New Year's Eve for the two parties to form a last-ditch deal. It was agreed that existing income tax rates would remain static, except for individuals earning over $400,000 a year and couples earning more than $450,000, who will see their tax rate rise from 35 per cent to 39.6 per cent. Legislation was also passed to delay an agreement on spending cuts until 1 March.

The deal averted an immediate drop in the US GDP and has bought more time for politicians to negotiate an austerity package. It was greeted with relief by the world's stock markets, with the two leading US indexes - the Dow Jones and the S&P 500 - both surging by around 2.5 per cent when they re-opened on 2 January. But, in reality, the fiscal cliff deal does little more than delay the real decision making for a further two months, when politicians must decide how to cut $110 billion from public spending.

Trouble ahead

More pressing still is the question of whether to raise the US debt ceiling - the limit placed on the total amount the US government is able to borrow - and by how much. The current limit of $16.394 trillion is close to being breached and will max out sometime in February. The debt ceiling did not form part of talks on the fiscal cliff but, without an agreement in the next few weeks, the US government will be forced to default on its obligations, such as paying public employees, possibly prompting a global economic panic.

Finding a solution, or rather a compromise, to these problems is the first major challenge of the new year. President Obama might soon be wishing 6 November had been Romney's night, after all.