Fiscal Cliff and Eurozone Crisis Could Deepen U.S. Economic problems
The economic effects of the expiring federal fiscal policies which raise taxes and cut spending, scheduled to take effect in January 2013 and popularly known as “fiscal cliff,” could be deepened by global uncertainty and the Eurozone crisis if Congress does not act and the current economic landscape does not improve. This could come about as a result of potential further downgrade of U.S. debt, US. Banks’ financial exposure, U.S. trade imbalances with the European Union (EU), as well as low consumer and business spending in the Eurozone.
In its report that covered the economic effect of the coming fiscal cliff on the U.S. economy in 2013, the U.S. Congressional Budget Office (CBO) estimates that the fiscal cliff will reduce the deficit in 2012 and 2013 by $607 billion (or about 4% of GDP) but will have a drag on the economy. Adjusting for the effects of lower consumer and business spending, higher unemployment and guarded business sentiment, the CBO projects the deficit will reduce to $560 billion but the economy will contract by 1.3% in the first half of 2013 followed by a normal growth of 2.3% in the second half. However, given the current global economic landscape and the possibility of the U.S. debt being downgraded if Congress is unable to reach further agreement on the U.S. debt ceiling, the resulting economic uncertainty can complicate any economic downturn from the fiscal cliff, resulting deeper than aniticpated downturn if the global economy and the crisis in the euro-zone does not improve.
The U.S. unemployment rate has been above 8 percent for more than three years and according to the Bureau of Economic Statistics, the U.S. GDP growth in the first quarter of 2012 was just 1.9 percent. In its latest World Economic Outlook, the International Monetary Fund (IMF) revised its baseline forecast and projected that the global economy will grow 3.5 percent in 2012, down 0.1 percentage points from the April forecast, and 3.9 percent in 2013, 0.2 percentage points lower than the baseline. According to the IMF, growth has slowed in the major emerging economies like Brazil, India and China due to the weak external environment and sharp contraction in domestic demand in response to capacity constraints and policy tightening. The IMF said the relatively minor setback in the projected global growth is based on the assumption that U.S. fiscal policy will not tighten sharply in 2013; that there will be enough policy action to ease financial condition in the Eurozone periphery – Ireland, Portugal, Spain and Greece -; and that efforts by major emerging markets to stimulate growth will gain traction. This implies if these assumptions do not hold, the world will see slower economic growth than projected.
Given the IMF’s projections, it will be in the national interest of the U.S. for Congress to avert a fiscal cliff and an impasse in 2013 debt ceiling debate in order to avoid potential further downgrade of U.S. debt as a result of political gridlock, and an economic contraction that could be worsened by resultant lack of confidence in the dollar and protracted Eurozone crisis. Indeed, further downgrade of U.S. debt could result in global uncertainty and investors viewing the U.S. dollar as high risk and selling off the dollar. Additionally, it will likely increase the cost of borrowing, thereby increasing U.S. debt service. Furthermore, it could result in the rest of the world no longer viewing the U.S. dollar as the safest global currency, resulting in investors moving away from the dollar, thereby further weakening and declining the dollar as the global most prominent currency. This could potentially result in the decline in foreign investment in the U.S. as well as further weakening of the economy and that of the Eurozone.
At a press conference in early July, the head of the European Central Bank (ECB) pointed out the Eurozone economy showed zero growth in the first quarter of 2012, following the contraction of 0.3% in the previous quarter and, indicators for the second quarter showed renewed weakening of economic growth and uncertainty. Recently, there has been a summit agreement by the European Union to create the Europe-wide banking union as a single banking supervisor along with direct injection of capital into banks from Europe’s rescue fund. However, economic contraction in the Eurozone periphery stemming from drastic austerity measures, and indeed contraction in the Eurozone in general, makes it likely, in my view, that the above measures and subsequent policy actions to strengthen the periphery’s economies will take time to have effect, especially if U.S. fiscal cliff results in global uncertainty.
In turn, the Eurozone crisis could have an adverse impact on the US economy through the financial system as well as trade and investment, and further deepen the economic woes of the U.S. The Bank for International Settlements reports that the direct and other potential U.S. bank exposure in December 2011 to Greece, Ireland, Italy, Portugal and Spain totaled $765 billion or 7.5% of U.S. direct and other potential exposures oversees. Of course, this data does not reflect hedges or collateral the U.S. banks may have in place to lower their exposure, and an analysis by the Investment Company Institute finds that U.S. money market funds cut their exposure to the Eurozone by 50% between April 2011 and April 2012. These notwithstanding, the risk of the Eurozone crisis affecting U.S. economic growth is quite substantial, especially if one also considers the depreciation of the Euro against the dollar.
The recent weakening of the Euro against the Dollar has the potential to widen the U.S. trade deficit with the Eurozone by making U.S. exports more expensive and import from the Eurozone cheaper, thereby costing U.S. jobs. According data from the US Department of Commerce, the Year-to-Date U.S. total export to the EU-27 (the 27 members of the EU) as of May 2012 was $113.95 Billion, while that of import for the same period was $157.39 Billion. Based on historical evidence, one can assume that this difference is expected to widen by year end. Considering the fact that the 15 member Eurozone form the majority of the EU-27 countries, including the three major economies in the EU, one can make the case that the greater share of this trade imbalance is with the Eurozone. An important issue here is that unless the European economy gets stronger to generate increased aggregate demand and the Dollar weakens against the Euro, many private individuals and businesses in the Eurozone may not be able to afford imported US goods, thereby widening the U.S. trade deficit and costing U.S. jobs.
The above problem, coupled with lower U.S. consumer spending from potential fiscal cliff-related economic contraction could deepen the economic problems of the U.S. and increase the deficit with broader ripple effects for the rest of the world. Therefore, Congress should do everything it can to avert a fiscal cliff. Given the size of the U.S. deficit, which is about $1.2 trillion or 7% of GDP, Congress can minimize the long-run costs of allowing the deficit to grow as well as the short-run cost of sharp fiscal contraction by enacting temporary extension to the Bush era tax cut while reducing and redirecting spending to productive areas of the economy.