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U.S. 'Fiscal Cliff' Could Take Canada's Economy Down With It, Economist Warns

U.S. 'Fiscal Cliff' Threatens To Take Canada Down With It

Engaged in a game of chicken with a teenage rival, Buzz Gunderson drives full throttle toward a steep cliff, intending to stay in the car only long enough to outlast his challenger, played by James Dean. But when he tries to jump to safety, his jacket gets caught on the door; his horrified peers watch as car and driver careen over the edge.

That iconic scene from the 1955 film Rebel Without A Cause could serve as an apt analogy to the potential outcome on both sides of the border if U.S. legislators don’t get their act together soon to deal with their “fiscal cliff,” says TD Bank chief economist Craig Alexander.

“That’s what we’re worrying about — an accident,” said Alexander. “Because rationality says that Washington will find a way to ensure that we don’t drive over a cliff.”

He is not alone in voicing concerns about the ability of a deeply divided U.S. Congress to come together and steer clear of the “fiscal cliff” — a combination of tax hikes and spending cuts that is threatening to shave 3.5 percentage points off of U.S. growth, and send the economy tumbling back into recession.

With Washington buried in a presidential election campaign that will end less than two months before the new year, when these measures start to come into effect, the OECD has warned that the “fiscal cliff” represents one of the major risks to global recovery.

“It is urgent that the political parties agree on detailed medium-term consolidation plans that will avoid this outcome and reduce uncertainty regarding the fiscal outlook,” the OECD cautioned.

In an interview with The Huffington Post, Alexander explained how the U.S. got on such a dangerous course and why the outcome matters so much to Canada’s economy — which, as he puts it, is “sitting in the back seat of the car.”

What is the fiscal cliff?

The fiscal cliff really has two main components. The first component is a series of tax measures that were put in place in past years to help boost the economy in the U.S. that are going to expire. The big ones are the Bush-era tax cuts, the payroll tax cut, extended unemployment insurance benefits and a variety of other measures.

The second part is that there are some automatic spending cuts that are associated with the outcome of the “debt ceiling” problems of 2011. There was an awful lot of difficulty in negotiating the terms under which the U.S. government would agree to raising their debt ceiling. In the end, the debt ceiling was in fact lifted but a [bipartisan] committee was formed to find fiscal savings over the next 10 years to pay for the increase in the debt ceiling.

If the committee couldn’t jointly find the savings, it would trigger automatic spending cuts beginning in 2013 and then running each year for the next nine years. We’re talking about $100 billion a year. The hope was this committee would come to an agreement about where the savings would come from. The committee didn’t come to an agreement, so the automatic spending cuts were triggered.

The total impact in terms of the blow to the economy if all of this is allowed to happen is that it would shave 3.5 percentage points off of U.S. economic growth. This is an economy that’s struggling to grow at two per cent. In other words, the arithmetic tells you that if the fiscal cliff is hit, it could drive the economy back into a recession.

What would that mean for Canada’s economy?

The simple answer is that close to 40 per cent of Canada’s economy is trade and more than 70 per cent of that trade is with the U.S. So where the U.S. economy goes, so too does Canada.

There’s an old adage that every time the U.S. economy sneezes Canada catches pneumonia. Usually when the U.S. economy has a bad recession it’s worse in Canada. This time around [in the 2009 recession] it didn’t happen, but nevertheless the Canadian economy did have a recession partly because the U.S. went into one.

If the U.S. economy is badly impaired by fiscal austerity, the impact will be felt in Canada very quickly, pretty much within a quarter. That’s how interconnected we are.

So the fiscal cliff is a very big issue for the Canadian economy. If the U.S. goes off the cliff, unless there’s big second-round effects, odds are it will be a mild contraction, but it’ll be a big setback. For Canada, if the U.S. goes back into recession, it probably means the Canadian economy stalls.

If no resolution is achieved, how soon will the U.S. reach the cliff?

This is where it gets a little complicated. The cliff hits at the start of the new calendar year, although there’s already some of the measures in the fiscal cliff that take a bite this year because some of them are on a fiscal year basis. It’s too late to avoid some of those effects but the bulk of the fiscal cliff is really an issue that kicks in at the start of the new year.

But Congress doesn’t have to resolve the whole cliff issue immediately after the election. What they can do is simply pass legislation to extend these programs for four months. All they have to do is agree to kick the can down the road until after the new year when there will be time to deal with it. Because we’re dealing with legislation, they can pass legislation that supersedes the other legislation in order to give them breathing room.

So how likely is it that the U.S. will actually drive over the edge?

Since everyone in Washington knows what the fiscal cliff is, and everyone knows what the numbers are, it’s clear that it can’t be allowed to happen. There is going to be some action taken to ensure the fiscal cliff isn’t going to hit the economy. Rationality tells you that. Just as there was really no chance the U.S. government would default on their debt just because they couldn’t raise the debt ceiling. Congress will find some way of putting off the fiscal cliff.

The problem is, we don’t actually know how it’s going to play out. Odds are, we will get some degree of fiscal consolidation. The only question is, how much? What are the fiscal programs that will be extended and which are the fiscal programs that won’t be extended?

In my forecast, I’m assuming there’s a fiscal drag in the coming year of 1.5 percentage points. The private sector is going to pick up, but there’s going to be some fiscal drag and that fiscal drag will push the economy back to a rate of two per cent.

I think of a cliff as an unexpected and sudden drop-off. Considering the advance warning afforded to policymakers in Washington, a cliff seems like the wrong analogy here.

I don’t think that’s true. If you’re driving down the road and there’s a cliff, you can see the cliff coming a long way out. The assumption is you’re going to turn away.

Think of the old movie Rebel Without A Cause. At the end of the movie, you have two kids and they’re driving cars toward a cliff. It’s a game of chicken. The one thing you know they’re going to do is turn away, because you can see the cliff a long way out. Well, one kid turns away, the other one waits too long. He starts to turn, realizes he’s gotten too close, tries to jump out, gets caught, and he and the car go over the cliff.

That’s what we’re worrying about — an accident. Because rationality says that Washington will find a way to ensure that we don’t drive over a cliff.

The fiscal cliff and debt ceiling debates have been pretty dramatic.

It’s a sign of the times. Traditionally, when you have a recession, the economy contracts for about a year but then you have really strong economic growth once the recovery starts. Consumers start spending in a really strong way because there’s pent-up demand. Businesses invest heavily and when the private sector is booming it allows the government to then rebalance fiscal policy. Governments always have to go through a fiscal rebalancing, because governments provide stimulus to help get the economy back on its feet. Afterwards governments have to reverse course because you can’t run deficits indefinitely.

This time around, it’s been exceptional in that the economic contraction [in the U.S.] was more than two times worse than a normal recession and then the economic recovery has been half of normal.

That means the government has to rebalance fiscal policy, but it has to do it at a time when the economy is weak. The economy is so weak that if the government suddenly turns off the taps, the economy will go back into recession.

Assuming the U.S. avoids disaster, how could the fiscal cliff be avoided or pushed further ahead, and what effect would those outcomes have on the economy?

If [the U.S. ends up] kicking the can just far enough to give Congress time to deal with the issue, I don’t think that would be viewed as a big negative. That would be viewed as what had to be done given how soon after the election the fiscal cliff was going to hit.

But if we don’t actually see any progress made in terms of taking on the fiscal challenges, then it becomes a very big negative. The government finances are unsustainable. The deficit is too large. A portion of that deficit is not related to the business cycle, it’s actually related to structural issues that the U.S. economy is facing.

Fed chairman Ben Bernanke has given several speeches where he has emphasized that the ball is in the court of the politicians now. There’s an inherent limit to what the central bank can do, and that progress on the fiscal front is absolutely essential. The fiscal uncertainty is weighing heavily on the economy. It’s influencing the willingness of business to invest and hire.

But if you want the upside scenario, if Congress reached a strong bipartisan deal that would address the medium-to long-term fiscal challenges, it could actually have an enormously positive fiscal impact on both the U.S. and Canadian economies. If that plan was credible and financial markets believed that it could be achieved, then you could bolster business confidence. You could bolster business investment. You could create a lot of economic growth and jobs. It would be unambiguously positive for the economic outlook.

It doesn’t sound like you’re banking on the upside scenario.

Well, if history is a guide, it doesn’t look likely.

What the debt ceiling fiasco showed was the fact that the parties were not capable of coming up with a compromise. In the end, America chose not to default on its debt, which was the only rational outcome. Then they chose to set up a committee to come up with the compromise they couldn’t reach before the deadline. But then the committee couldn’t come up with an agreement.

So there’s a general sense that the political environment was too toxic, and we couldn’t get progress on this issue. The hope is that once the upcoming election is over, the political situation will be less intense, and as a consequence, compromise can then be made.

The Game Of Chicken

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