Can US pull back from the brink?

No sooner had the sound and fury of the US presidential election subsided than the attention of the world's media and opinion makers turned to the ''fiscal cliff''. It sounds perilous, and it is, but you're not alone if you're not exactly sure why.

The fiscal cliff is one of those clever verbal short cuts that lodge in public discourse. It makes insiders nod sagely and everyone else scratch their heads, but it boils down to this.

The US has a budget deficit of close to $US1.1 trillion, which amounts to more than 7 per cent of the nation's gross domestic product (GDP). It's a figure that puts Australia's preoccupation with whether Wayne Swan will produce a budget surplus or a small deficit into perspective.

Put simply, a budget deficit occurs when governments spend more than they earn. The only way for the US government to reduce the deficit is to cut spending, increase taxes, borrow money, or a mix of all three.

But the deficit is only part of the problem the US is facing. Deficits add to national debt because governments have to borrow money to maintain their spending on benefits and services. America's national debt stands at $US16.1 trillion, which exceeds 70 per cent of GDP, a level not seen since 1950.

According to the US Treasury, debt is likely to hit a previously agreed ceiling of $US16.4 trillion by the end of the year. If nothing is done, the government will have to stop spending because there will be no money left in the kitty. But with an ageing population and rising healthcare costs, the budget needs to be put on a more sustainable path - and quickly.

That's where the fiscal cliff comes in. ''Fiscal'' refers to government policies dealing with tax, welfare spending and general government expenditure. It's the culmination of a decade of fiscal stimulus measures designed to boost economic activity that has the pundits worried.

On January 1, the axe is set to drop on a total of $US670 billion worth of tax cuts and government spending, a move viewed by many as too much, too fast. That's the cliff.

If all these stimulus measures are removed from the economy on January 1, it will almost halve the budget deficit overnight, but it will also reduce economic activity (or GDP) by 4.3 per cent.

''That's great for the budget deficit, but it would happen too quickly,'' the chief economist with AMP Capital, Shane Oliver, says. Like Wile E. Coyote chasing Road Runner to the edge of the canyon, the pundits worry that the US economy will plunge headlong over the cliff and into a deep recession in the single-minded pursuit of budget savings.

The US economy is growing at a rate of about 2 per cent. Oliver says cutting household incomes so suddenly and reducing economic growth by 4.3 per cent would drag the economy into recession.

According to the US Congressional Budget Office - the country's independent number cruncher - acceptance of the fiscal-cliff measures in full will not only drive the US economy back into recession next year but push the jobless rate to 9.1 per cent by the end of next year.

This is not a road that policymakers want to travel. Recent images of mass demonstrations and rioting in Greece and Spain, sparked by rising unemployment and extreme austerity measures, are an indication of what might lie ahead if the US heads over the cliff.

The problem is, the politicians can't agree on a solution. Republicans want the tax cuts to continue in full and the emphasis placed on spending cuts, especially on social welfare and health, while Democrats want a mix of tax increases and spending cuts focusing on defence. President Barack Obama has suggested extending the tax cuts, except for people earning more than $250,000.

Adding to the sense of uncertainty is the fact that the period between the November presidential election and the new year is traditionally a lame duck session of Congress.

''There is already evidence that [the uncertainty] is affecting business confidence, with delays in hiring and capital spending until the problem is resolved,'' Oliver says.

President Obama and the Republican-led Congress have several options. They can go over the fiscal cliff and proceed with all the tax increases and spending cuts. Apart from the financial pain for households, this would be self-defeating for the government if it ends up paying out more in welfare for the newly unemployed.

Alternatively, they can kick the can down the road by reducing the size of the cliff and spreading out the spending cuts and tax increases over the next few years. Oliver says this would reduce the deficit but allow the economy to hum along, avoiding the social dislocation that fiscal austerity is causing in Europe.

Oliver says another option is to raise the debt ceiling again in return for spending cuts over the next decade. These are critical issues for the US, but Australians may wonder why it is such big news here. The short answer is that what happens in the US affects the global economy and investor confidence.

''The US is no longer Australia's biggest trading partner, China is. But the US is China's second-biggest export market outside the euro zone. So a recession in the US [on top of the one in Europe] would result in less demand for our raw materials from China,'' Oliver says.

That's a cliff Australians would hope to avoid.

The US fiscal cliff has been a long time in the making. It began in the recession of 2001 with George Bush's tax cuts for middle- and high-income earners, plus reductions in tax rates for dividends and capital gains.

In the wake of the financial crisis, Obama cut the rate of payroll tax that is taken out of workers' salaries to pay for social security and he extended the length of time people can claim unemployment benefits.

In August last year, these ad hoc measures became a cliff when they were extended to January 2013 and Congress agreed to the Budget Control Act. This cut spending on health and defence as a trade-off for increasing the country's debt ceiling to $US16.4 trillion.

This story Can US pull back from the brink? first appeared on The Sydney Morning Herald.