“Fiscal cliff” was an impending event that has been averted for now. It had the potential of tripping over the financial markets in what has otherwise been a phenomenal year. The analogy that comes to mind is that of the Y2K way back in 2000. However, unlike the Y2K that passed out without a whimper, the effects of the “fiscal cliff” may have proven to be far-reaching.

MIDNIGHT HOUR

In August 2011 when the financial markets were on a boil, the US Senate increased the debt ceiling, which avoided any impeding threat of the US government falling back on its liabilities and interest payments. However, during the discussions, both sides concurred that this mounting Federal debt was unsustainable and hence had to be brought under control. But because of the deep ideological differences between the Republicans and Democrats, the two parties were not able to arrive at an understanding on how to reduce the US fiscal deficit. It was then decided that failing to reach an agreement by December 31, 2012 would lead to automatic, across-the-board spending cuts and increase in taxes due to the expiration of the Tax Relief Act of 2010. It was projected by the Congressional Budget Office that a sharp cut in the government spending may result in the US economy entering into a mild recession in the next fiscal.

Some of the highlights of the deal stuck at the midnight hour includes tax increases for individuals earning more than $400,000, both on income and capital gain/dividend, increase in real estate tax for estates for estates of $10 million per couple, extension of unemployment benefits and a two-month sequester to decide on the $1.2-trillion spending cuts (over the next 10 years) during which time 50 per cent of the cuts would come from defence and 50 per cent from non-defence programmes.

CRUCIAL PERIOD

However, the slugfest has not yet ended. The details of the spending cut are yet to be worked out; the next two months are going to be very important not just for the US but for the entire world, as any wrong move would mean a sharp shrinkage in the credit/money supply. This could lead to a bout of deflation in asset markets and the real economy.

Under the current fiat monetary set-up, it is the loan operation conducted by the banks i.e. banks giving loans to people, corporates and governments, is what creates the money supply. In essence, when someone approaches the bank for getting a loan then under the prevailing system, the banks create credit out of thin air and lend it to the borrower which is simultaneously deposited in the bank account. The loans constitute an asset on the banks’ balance sheet and the deposits an equivalent liability. So, in other words, any loan taken by an individual, corporate or government increases the money supply and any loan paid back or defaulted reduces the money supply.

The financial crisis of 2008 began with the deleveraging of the financial and consumer sector of the economy, a process that still continues. This would have resulted in a prolonged reduction in money supply, with its deflationary consequences. However, this scenario was averted due to the coordinated actions of the Federal Reserve and US government. The US government, and governments the world over, increased their fiscal deficits. The reduction in the credit/money supply on account of the financial and consumer sector was offset by the increase in credit due to the higher fiscal deficits. Just so that this trillion dollar deficit spending doesn’t overwhelm the system, the Federal Reserve brought out its various versions of QE.

The process of deleveraging in the consumer and financial sector still continues and thus any sharp and sudden cut in the credit off take of US government has the potential to bring to an abrupt end the uneasy calm brought about since 2008.

Let history not repeat itself. The gradual recovery following the deep economic slumber of 1931 was brought to an abrupt end by the sudden cut in government deficits in 1937. So as the drama unfolds over the next couple of months, the world awaits if the New Year would bring about a financial dawn or dusk.

(The author is an independent financial consultant at Random Chalice Investment Research.)

Related Topics
comment COMMENT NOW