Obama: from elation to potential economic nightmare

The election campaign lasted months, but President Obama has only a matter of weeks to negotiate a deal to avoid a recession.

Who coined the phrase ‘fiscal cliff’?

It was first used by Ben Bernanke, the chairman of the Federal Reserve, who said in February that the US faced “a massive fiscal cliff of large spending cuts and tax increases” on 1 January, 2013.

What is the ‘fiscal cliff’?

Legislation passed by the US Congress to cut the budget deficit will mean automatic tax increases for most Americans and spending cuts of $600bn – unless Democrats and Republicans strike a deal.

The fiscal measures amount to 4 per cent of American output, twice the rate at which the economy is growing, and mean a 10 per cent cut in government spending. This would result in a halving of the budget deficit in just a year.

Employees would higher income and payroll (national insurance) taxes, which would fill most of the $600bn gap.

Where would the spending cuts fall?

Social security payments and pensions are protected from spending cuts, but other programmes, including defence, are not. One of the areas that would be hit is emergency unemployment benefits.

Why is America in this situation?

Like many European countries hit by the 2008 banking crisis, America took steps to protect itself from the worst effects of the resulting economic downturn.

The Bush administration cut taxes to stimulate the economy, and when Barack Obama was first elected in 2008, he decided to extend those cuts. These are due to come to an end at the beginning of next year.

Democrats and Republicans in Congress also tried to reach a deal over public spending, in an effort to reduce the budget deficit. If they failed to do so, which is what happened, automatic cuts would come into force in January 2013.

What effect would the ‘fiscal cliff’ have on the US and world economy?

The fiscal measures would have adverse consequences for the US and world economies. In all likelihood, America would be plunged into a double-dip recession, which would damage the economies of countries like Britain which are reliant on trade with the US.

Work and Pensions Secretary Iain Duncan Smith has said it could have a “bigger” impact on Britain, which has just emerged from its own double-dip recession, than the crisis in the eurozone.

This is because of the trade links between the two countries and the fact that Britain is America’s biggest foreign investor.

What is the solution?

The “fiscal cliff” could be avoided if Democrats and Republicans clinch a deal, perhaps with Barack Obama’s party agreeing that tax cuts for high earners should be extended and Republicans accepting that spending cuts should be delayed.

This would mean the budget deficit would not be cut as quickly, but for many politicians this would be a price worth paying if a double-dip recession is avoided.

But as a result, it would take longer to cut the deficit, leading to a possible rise in borrowing costs for the government.

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It is feasible that Democrats and Republicans fail to find a solution before January, but are stung into taking action afterwards when the economy starts to falter.

The Congressional Budget Office has calculated that doing nothing – allowing the tax rises and spending cuts to proceed – would lead to a 0.5 per cent fall in output and higher unemployment in 2013, whereas if the tax rises are extended, there would be growth of 1.7 per cent, but total debt would rise.

Taking action would prevent a recession, but the deficit would still have to be dealt with in the future.

Where does President Obama stand?

Barack Obama would support a temporary extension of the Bush-era tax cuts, as long as those earning more than $250,0000 a year were excluded.

He has talked about striking a “grand bargain” with the Republicans, who control the House of Representatives. But when he last tried to negotiate with House Speaker John Boehner, a Republican, it did not go smoothly.