Monday, January 07, 2013

The U.S. Fiscal Cliff and Canada

The term “fiscal cliff” has conjuredup a powerful image of the U.S. economy falling into a pit so deep that there was no hope of climbing out. The ramifications of that mighty fall would be felt around the world, with the idea that without the U.S. world economies would stagger and fall into their own abyss.

Fortunately, the U.S. government came to an agreement last Tuesday – New Year’s Day -- that averted the downfall. Global markets responded positively to the news.  Stocks, commodities and some currencies like the Canadian dollar have rallyed in the wake of the agreement to deal with a combination of tax hikes and spending cuts that threatened to plunge the U.S. back into recession.

While the cliff has been avoided, there is still plenty of unresolved business to be completed over the next couple of months.

It was U.S. Federal Reserve chairman Ben Bernanke who coined the term “fiscal cliff” and wanted American politicians and their constituents to feel his alarm over this "cliff" and the economic danger it posed. Although aimed at a U.S. audience, the whole world was listening. The general consensus seemed to be that if the Americans couldn’t figure out a way of avoiding the cliff, the potential damage caused by that failure on the Canadian and the global economy could be huge.

What was the fiscal cliff?

The “cliff” referred to the more than $600 billion U.S. worth of spending cuts and tax hikes that were due to automatically take effect as of Jan. 1, 2013. Most of this $600 billion – about $500 billion – was in tax hikes that would have hit the vast majority of Americans. The spending cuts amount to about $110 billion. The term “cliff” was a bit of a misnomer since the full impact of those spending cuts and tax hikes would not takes place on January 1, but were spread out over the whole year. So, if an agreement took place over a few months, the economy would still have been okay.

Why would Canada care?

Bilateral trade between Canada and the U.S. amounts to more than $1.7 billion a day. It’s vital for Canadian exporters to have a financially healthy and confident U.S. consumer. TD deputy chief economist Derek Burleton noted that U.S. tax hikes have a bigger impact on Canadian exports than spending cuts, which tend to matter more domestically because Canadian trade with the U.S. is largely concentrated in consumer goods and business investment – items which will likely be hit harder by an increase in taxes.

What now?

Still a risk to the U.S. economy  is how $110 billion in spending cuts that have now been delayed for two months in this agreement will be tied to an increase in the debt ceiling that will be required by February or March. For now markets are surging and confidence is high.

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