Financial markets all over the world are relieved with the US Congress narrowly managing to avert the fiscal cliff. The term first used by Ben Bernanke, the chairman of the Federal Reserve, the fiscal cliff would have led to forced reduction of the budget deficit by about $600 billion (32.64 trillion), starting 1 January. A sudden reduction of budget deficit by a combination of tax hikes and spending cuts, experts believe, would have resulted in a recession in the US economy with global consequences. According to the agreement reached on I January, among other things, tax rates will increase for families earning at least $450,000 a year, sparing 98% of the taxpayers from higher taxes.

What the fight was about

The US government is running a very high budget deficit and fiscal 2012 was the fourth consecutive year when it saw a $1 trillion-plus deficit, which is considered to be unsustainable in the long term. Earlier, a 12-member bipartisan committee, also known as “super committee", was formed to address the issue, but it could not agree on any deficit reduction plan. Had the US Congress not approved the deal, the self-imposed deadline (1 January) of deficit reduction would have triggered.

The basic issue is that while the Republicans were not in favour of any increase in tax rates, the Democrats were against any cut in social sector spending. Even from the pure economic perspective, for an economy, which is witnessing slow recovery from the shock of a financial crisis and a recession comparable with the Great Depression, any hike in taxes or spending cut would not have been advisable. However, at the same, it is not possible to run large deficits forever. The Federal Reserve, which is buying the bulk of the government bonds from the market and not allowing yields to move up, has indicated that it may not have unlimited fire power. Also, in order to keep the faith in the US government bonds alive, it was necessary to signal seriousness on government deficit reduction. Though the US government bonds are treated as the safest in the world, ever-increasing supply can affect the appetite of the market.

Has the problem been solved?

The issue is expected to resurface very soon as the Congress is yet to decide on spending cuts and will also have to take a call on debt ceiling. The US government will reach the cumulative borrowing limit of $14.6 trillion by mid-February and if the limit is not revised, it will default on its obligation. However, since the tax hikes have been passed, chances are that the Democrats may now agree to cuts in spending; however, one should keep fingers crossed till the time the agreement actually takes place. The debate on debt ceiling will be the next milestone that markets across the world will watch out for.

Close