A year after the US went close to defaulting, the political nature of the settlement of that crisis — the introduction of automatic spending cuts, allied with the expiration of a host of tax cuts in early 2013 unless there’s agreement on precise cuts and extension of the cuts — has returned to become the single greatest threat to the health of the American economy, and through it, the rest of the world. In fact, if not resolved by the end of this year, the US economy could be dragged by the cuts into a recession early in 2013 by the cuts.

This approaching politically driven crisis is a much greater threat to the outlook for the US economy than the slowing pace of activity, as highlighted by the weak survey of manufacturing for June, according to the International Monetary Fund.

The settlement of the dispute last year (which also saw Standard & Poor’s cut America’s credit rating to AA plus from AAA), has produced what US commentators are calling a “fiscal cliff” where the spending cuts and tax rises produce a sharp contraction in US economic activity early in 2013. The current members of Congress have from the elections in early November to December 31 to resolve the situation by agreeing to specific tax cuts and renewing all or some of the tax cuts (called the Bush cuts), as well as several other measures. The composition of the Congress changes on January 1, 2013, as does the presidency, depending who wins the poll. On top of this, the debt ceiling, which was the focus for the impasse a year ago this month, will again become an issue in the March quarter of next year.

Now the International Monetary Fund has joined the fray, urging the US to quickly resolve the situation in the latest review of the American economy, released overnight. The fund has provided some estimates of the damage the impasse could do to the US economy if the fiscal cliff is not removed. It seems US GDP growth falling to less than 1% next year if the situation remains unresolved (the IMF’s existing forecast is for 2.25% growth if the situation is worked out). The forecast of less than 1% growth for all of next year includes a period of negative growth early in the year.

Economists estimate that the impact of the fiscal cliff tax and spending plans would shrink the deficit by about 4% of gross domestic product in 2013. The fund said overnight these policies “could reduce growth to well below 1%, with negative growth early next year and significant negative repercussions on an already fragile world economy”. It said the US Congress should replace the fiscal cliff with a program of small deficit reduction in the short term with a longer-term fiscal sustainability program. IMF head Christine Lagarde said at a later press conferences that these small deficit cuts should total about 1% of US GDP.

The fund also said in its final report that the US congress must also quickly pass another increase in the federal debt ceiling that is expected to be needed in early 2013, so as to avoid the market disruption and uncertainty we saw a year ago.

Looking out over the next 18 months to two years , the IMF sees little chance of the US economy recovering to the 3% growth rate seen at the end of last year.

“Growth is likely to remain modest in the next two years, constrained by household deleveraging, fiscal restraint, and subpar global demand. Staff expects growth to be 2% in 2012 and about 2.25% in 2013. Consumption is expected to be held back by households continuing to repair their balance sheets amid a sluggish recovery of house prices, while weak growth in US trading partners and the appreciation of the dollar are likely to weigh on exports,” the fund estimated.

That means no real rebound from the weak slowdown in the first quarter of this year when growth was an annual 1.9%, a rate underlined by the survey of manufacturing for June.

Peter Fray

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