Satyajit Das: Fiscal cliff not big enough to solve US debt problem

Ironically, the approaching fiscal cliff (scheduled reductions in the US budget deficit) may, at least on the face of it, "improve" public finances, reducing the deficit and slowing the increase in debt levels. But the fiscal cliff will not of itself solve America's financial problems. It is simply not high enough.

In January, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling, allowing the government to continue to borrow. Several temporary tax cuts will expire. The total amount involved is around $500bn (£300bn) through to September next year. Automatic spending cuts will also commence, totalling $600bn per year and $6.1 trillion over 10 years.

The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to 5 per cent of GDP. The non-partisan Congressional Budget Office (CBO) has estimated that the tax increases and spending cuts would reduce output by 3 per cent and increase unemployment to 9.1 per cent by the end of 2012.

President Barack Obama's ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending.

Mr Obama asserts that he has a mandate to reform the budget, especially increase taxes on wealthier Americans. John Boehner, Republican House Speaker, has been conciliatory, signalling a willingness to consider some higher taxes. A short-term compromise will be needed, entailing extension in some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.

Mr Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1m a year (rather than the $250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as higher Medicare retirement age and changes to indexation of social security benefits for inflation. There would probably also be cuts in spending on defence and other social welfare programmes.

The fiscal cliff if it is avoided, or the measures likely to be adopted, may not to be enough to address the deep-seated problems. What is needed is a radical overhaul of the tax system, including probably a value-added tax and wind-back of complex deductions and subsidies. What is also needed is a review of all spending, including defence and social welfare, to better target expenditure and align it with tax revenues.

But even with this action, without strong economic growth and falling unemployment, it is hard to see a significant improvement in American public finances. A recent CBO report concluded that "[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary". This means the US will probably still spend more than it gets in taxes, so US government debt will rise. This will force the Federal Reserve to continue existing policies, especially debt monetisation by purchasing government bonds and devaluation of the currency.

Given that the US constitutes around 25 per cent of the global economy, it is unlikely America's problems will stay in America. US dollar devaluation will create pressure for appreciation of other currencies, forcing other nations to implement measures, such as zero interest rate policies, QE programmes or capital controls. Foreign investors in US dollars and government bonds are likely to suffer losses.

How long the US can continue its profligate ways is unknown. But as the economist Herbert Stein observed: "If something cannot go on forever, it will stop."

Satyajit Das is a former banker and author of 'Extreme Money' and 'Traders Guns & Money'