Could renewed U.S. economic strength turn the fiscal cliff into a fiscal ramp?

October 18, 2012

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The term ‘fiscal cliff’ has now safely transitioned from economic jargon to popular cliché. But how worried should Americans be about the growth-stunting mélange of expiring tax cuts and spending reductions set to begin kicking in at the start of next year?

Economists widely believe that if Congress fails to come to some sort of agreement on the budget, the U.S. economy would plunge into a deep recession. RBS economist Michelle Girard, however, thinks a recent pick up in U.S. economic activity could offset some of the cliff-related weakness.

While uncertainty over the fiscal cliff dominates most conversations, the relative strength of the underlying U.S. economy should not be forgotten. The expansion is today on firmer footing today than at any point in the past three to four years. No major economic imbalance exists. Moreover, headwinds that have hindered the pace of recovery are fading.

The bottom line is that the US economy may be better positioned to withstand greater fiscal drag than many currently believe. While going over the so-called fiscal cliff (in its entirety) would almost certainly lead to a sharp contraction in economic activity in early 2013, the improving economic base we now observe leads us to conclude that such a downturn would likely be short-lived.

The latest sign of strength came from a report showing housing starts surged 15 percent to their strongest levels in more than four years, adding to optimism following September’s drop in the jobless rate to 7.8 percent.

In response to a MacroScope tweet highlighting the increase, Markus Schomer, chief economist at PineBridge Investments, tweeted: “Another positive surprise – does the ‘cliff’ not matter anymore?”

That might be a slight overstatement given a very fluid and acrimonious U.S. political situation. Still, Girard highlights a number of reasons for optimism:

• US corporations remain flush with cash and the nation’s banks are back on solid financial ground.

• Household balance sheets are being repaired more quickly than anticipated. Indeed, the deleveraging trend among consumers has nearly run its course, while the rebound in equity prices and, more recently, home values has led to a sharp recovery in the value of household assets. As a result, consumer balance sheets are as strong now as they were before the recession began.

• Sales of big-ticket items (such as autos) have picked up to multi-year highs.

• Most importantly, the beleaguered US housing sector has finally begun to turn up, with positive and broad-based implications ranging from increased consumer confidence to improved labor market mobility and reduced pressure on bank balance sheets.

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