November 9, 2012


Title: Are fiscal cliff worries overblown?

Subtitle:  Budget battles south of the border highlight Canada’s exposure to the US economy.


As US politicians head back to Washington following last week’s election, they won’t have long to celebrate results. That’s because a time bomb, known as the “fiscal cliff” will be waiting for them, when they get there.


This $560 billion of tax increases and spending cuts set to occur during the next calendar year, will take effect starting January 1, 2013, if Congress is unable to come up with a deficit reduction package. Further tightening would follow in ensuing years. Former US Treasury Secretary Larry Summers, now a Harvard professor, told a forum hosted by the Canada 2020 think tank on Thursday that the results would be “catastrophic.”


Ironically, it was politicians themselves that put this gun to their heads, when Democrats and Republicans were unable to reach a budget deal earlier this year. Instead they voted a series of tough measures that would give everyone an incentive to compromise later, so they those measures would never need to be implemented.


Canada would take a hit

However as Canada’s Finance Minister Jim Flaherty recently noted, if fiscal cliff tax increases and spending cuts do go into effect, the United States will slip into a recession. If that happens we won’t be far behind. Flaherty though makes an important point which is that US fiscal cliff troubles highlight how dependent we are on our southern neighbor.


Canada is a trading nation, with our businesses highly dependent on foreign markets. For example in 2009, exports comprised 30 percent of Canadian GDP. The United States alone accounted for three quarters of that total.  (Exports account for only about a tenth of US GDP).


That means is that if the US heads into recession, and businesses and consumers there cut consumption, it won’t take long for Canada to feel it. The result would be a drop in output here, likely accompanied by falling corporate profits, stock values and residential housing prices.


That said it is hard for seasoned political watchers to take the “fiscal cliff” drama too seriously. For one, Congress has been upfront about the fact that the large potential spending cuts and tax increases were only put in place to force both Republicans and Democrats to reach a deficit reduction deal.


Polarization hampers comprise

However due to the increasingly polarization in Congress that’s not as easy as it sounds. Over the years at the state level, where Congressional risings are zoned, both parties have played around with district boundaries to improve seat totals and to create “safe” ridings for powerful leaders, filled with voters known to be friendly to the cause. It’s as if instead of voters choosing politicians, it is now the politicians who are choosing their voters.


This has led to highly partisan ridings, led naturally, by highly partisan representatives. Many are more afraid of primary challenges emerging from their own districts than they are by the other party. The defeat of six-term Republican senator Richard Lugar by a relative unknown earlier this year sent a strong warning to politicians who compromise too much.


However by setting up the fiscal cliff, Democrats and Republicans can shield themselves partially from Lugar’s fate. The move sets the stage for a scenario in which politicians can compromise, yet go back to their districts as heroes for having “led” the country from disaster (which they themselves created).


A deal is possible

As a result, seasoned economics professionals, though cognizant of the damage that would occur should Congress fail to reach a deal, remain confident that the parties will be able to come together. As Benoit P. Durocher, a senior economist at Desjardins Economic Studies notes, the Bank of Canada’s own base-case scenario assumes that the “fiscal cliff”, will be avoided. This, says Durocher, gives Congress maneuver room, to implement some tough measures, by claiming that “at least we avoided the worst.”


That said, if Congress does avoid pushing the United States over the fiscal cliff, it will only do so by in part kicking the can down the road and implementing tax increases and spending cuts later on, while running bigger deficits right now. The problem is that excess borrowing is what got America into trouble in the first place.


Doing more of that now, will likely only increase the pain later.



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