Understanding the fiscal cliff

By Bruce Sellery on November 14, 2012
Estimated reading time: 4 minutes

Can the U.S. avoid a recession? Bruce Sellery says the answer to that question will depend on what happens in Washington in the next few months.

Question

I have been hearing so much about the “fiscal cliff” in the U.S. What do I really need to know?

Answer

Ever since Barack Obama’s landlord—the American electorate—extended his lease on the White House by another four years, the term “fiscal cliff” has been the phrase that pays. “Fiscal” refers to the U.S. budget and “cliff” refers to what the American economy will almost certainly fall off of if something isn’t done to alter course.

The so-called cliff has two parts: An increase in taxes and a decrease in government spending. For starters, a number of significant tax cuts are scheduled to expire at the end of the year. If nothing is done, the average American household will pay an additional $2,000 to $3,000 more in 2013. If that wasn’t enough, at the same time government spending is scheduled to fall by approximately $800 billion. Budgets at the Defense Department and the Federal Emergency Management Agency, or FEMA, face massive cuts, with the latter being particularly sensitive politically in the wake of Hurricane Sandy.

Getting close to the “cliff”

For years the U.S. government has been spending more than it has been bringing in through tax revenue. The wars in Iraq and Afghanistan played a big part in that. Then the economy stalled, the housing market melted down and the banking crisis exploded. In response, U.S. politicians poured huge amounts of money into the system to keep the economy on the rails: they bailed out banks and car companies, and they wrote cheques for other government programs to stimulate growth.

It worked, to a point. The economy held on and the tough choices to fix the budget gap were deferred. But they could not be delayed forever. In order to get enough people to agree to such aggressive stimulus measures, all parties agreed to a pretty serious consequence: Make progress on reducing the deficit by December 31^st, 2012 or else the tax cuts would end and government spending would be slashed.

Canada’s train is firmly hitched

It would nice if Canada could just sit back and quietly “tsk, tsk” the bickering politicians down south. Unfortunately, we cannot. Our economy is firmly hitched to that of the U.S.: if theirs goes off the cliff there is very little that we can do to avoid ours from going with it. Here’s an oversimplified version of how the scenario unfolds:

Suzanne and Thomas live in Austin, Texas. They don’t have $2,000 sitting around to pay these new, higher taxes so they have to cut their spending. They shop less and stay home more. All the families in their neighborhood start doing the same and soon the businesses on Main Street have to lay off employees. Those employees cut their spending and stay at home and the vicious cycle continues. Suddenly, there is less demand for the goods that Canada sells to the U.S. and so Canadian companies start to lay off employees, who in turn shop less and stay at home more. Pretty soon what happened to Suzanne and Thomas in Austin, Texas is happening to Katrina and Pat in Oakville, Ont. And so on.

Brokering a compromise

Everyone in Washington knows that something needs to be done about the fiscal problem. The whole bar brawl is about exactly how to handle the “fiscal cliff.” Do nothing and the economy goes into a recession. Extend the tax cuts and hold government spending flat and the deficit explodes. Both are ugly choices, so the Republicans and Democrats will need to broker a compromise somewhere in between. But given that the two sides can’t even agree on what to stock in the Congressional vending machines, this will be no easy task.

The lesson for personal finance

I think there is a very important lesson for individual Canadians to take away from the fiscal cliff story. That is that no one can live beyond their means forever without dealing with consequences. Not even a super power like the United States.

So before you face your own cliff, take a close look at the income you have coming in and compare it to the expenses you have going out. Be very sure that the former exceeds the latter, lest you face your own ugly choices down the road.