Canada's stake in the U.S. 'fiscal cliff'

As metaphors go, "fiscal cliff" must surely rank as one of the most striking ever coined. It implies something scary, irreversible, even fatal.

U.S. Federal Reserve chairman Ben Bernanke – normally one to confine his vernacular to dry "fedspeak" – must have known that when he first used the term in Congressional testimony earlier this year.

Bernanke wanted American politicians and their constituents to feel his alarm over this "cliff" and the economic danger it posed.  To put it bluntly, he wanted them to get it.

Bernanke may have been aiming his remarks at a U.S. audience. But the whole world was listening... and with good reason. The general consensus seems to be that if the Americans don'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 exactly is this 'fiscal cliff'?

The fiscal cliff refers to the more than $600 billion US worth of spending cuts and tax hikes that are due to automatically take effect as of Jan. 1, 2013 if nothing is done to change the situation. Most of this $600 billion – about $500 billion – comes in the form of tax hikes that will hit the vast majority of Americans. The spending cuts amount to about $110 billion – half in defence.

It's important to point out that the use of the word "cliff," however effective, is a bit of a misnomer here. It's not as if the full impact of those spending cuts and tax hikes takes place on Jan. 1. They're spread out over the whole year. So all is not lost if an agreement takes a few months rather than a few weeks. Still, the metaphor's power persists.

Won't tax hikes and spending cuts reduce the U.S. deficit?

Absolutely. If Congress does nothing and the spending cuts and tax increases all go ahead, the non-partisan Congressional Budget Office estimates that the federal deficit in fiscal year 2013 would be chopped roughly in half, to $641 billion. 

But deficit reduction of that speed and magnitude would come at a steep cost as hundreds of billions of dollars disappear from the economy. The CBO estimates that U.S. unemployment – now at 7.9 per cent – would balloon to 9.1 per cent by the end of 2013. The tax increases, due mainly to the end of a temporary cut in Social Security taxes and the expiry of the Bush-era tax cuts, would see almost 90 per cent of Americans pay more tax next year.

The Brookings Institution Tax Policy Center estimates that the tax bill for the average U.S. household would rise by almost $3,500. A tax hit that big, most experts agree, would be enough to give the U.S. consumer a severe case of shell-shock and drive the economy back into recession.

Why should Canada care?

The U.S. economy is, of course, not just a domestic enterprise. Bilateral trade between Canada and the U.S., for example, amounts to more than $1.7 billion a day. A financially healthy and confident U.S. consumer is vital for the sake of Canadian exporters. Realization of the full fiscal cliff could cause real pain on this side of the border, according to politicians and economists.

"The world would be immensely helped if the Americans could deal with this immediate issue," Prime Minister Harper said recently.

His finance minister echoed that concern, telling reporters that the fiscal cliff is the "biggest" international economic risk facing Canada and other countries.

"Were the entire fiscal cliff risk to become reality, the effect on U.S. GDP, according to the Americans themselves, would be four to five per cent, which would put the U.S. economy into recession quite quickly and the Canadian would follow shortly thereafter," Jim Flaherty warned the day after the U.S. election. "We’re all concerned that it’s an immediate problem within the next 60 days that needs to be dealt with."

Economists at TD Bank estimate that failure to reach any agreement to avert the cliff would shave 1.2 per cent to 1.8 per cent off Canada's real GDP in 2013. Under this scenario, Canada would just barely manage to avoid a recession.

TD notes that U.S. tax hikes have a bigger impact on Canadian exports than spending cuts, which tend to matter more domestically. "This is 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," says TD deputy chief economist Derek Burleton.        

Can the cliff be avoided?

Given the apparent stakes, you'd think the president and the Congress would be able to agree on some compromise so the fragile economic recovery wouldn't be derailed. But they've been trying to do exactly this for the better part of two years. The Republican-dominated House of Representatives has wanted no part of a solution that would see any tax increases. And while they're in favour of spending cuts, they're not as enthusiastic about heavy cuts in defence spending. Democrats, for their part, want the Republicans to agree on higher taxes for those making above $200,000.

After the Nov. 6 election, both camps made neighbourly noises about working with the other side. Many observers do think that some compromise will be worked out – either in the next few weeks, or early in the new year. The thinking here is that the political and economic consequences of driving off the cliff would simply be too severe. So look for a lot of last-minute negotiating on Capitol Hill.

But lingering gridlock on this and many other issues is still a possibility. The fact that the Dow Jones industrial average took its biggest plunge of the year the day after the election showed that investors are worried that the political deadlock will continue, hobbling growth and leading to even more market volatility.