If the U.S. jumped off a cliff, would Canada do it too?

Economists, by and large, are not a dramatic bunch. Like bank executives and government leaders, their views on the future are reported and repeated by the media, far and wide. Their words have the power to become self-fulfilling prophecies. For example, if a well-regarded economist comes out and says, "the markets will crash this week," sure enough, many investors will panic and sell their investments quickly to avoid the possibility of a crash — in effect, causing a crash. As a result, most economists, bank executives and government leaders tend to keep their statements carefully bland and full of wiggle words, such as "cautiously optimistic".

So it was pretty surprising when one of the most high-profile economists in the world - Ben Bernanke, chairman of the United States Federal Reserve - declared the situation facing the US as a 'fiscal cliff'. Conjuring up images of an economy hurtling off a cliff and falling to certain death? Harsh words for a top bureaucrat. You don't have to follow politics or global economics to understand that this sounds bad.

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Where did this fiscal cliff come from?

Mr. Bernanke coined the term, fiscal cliff, to describe a whole bunch of tax increases and government spending cuts that are scheduled to come into effect on January 1, 2013.

If you think way back to the summer of 2011, you might recall that President Obama (a Democrat) and the House of Representatives (mainly Republicans) were stuck in a stalemate. The country's debt ceiling needed to be legally raised so that it could borrow more money in order to make its existing debt payments. (A stressful way to live for anyone, no?) If the ceiling had not been raised, the US would have missed its next round of debt payments and fallen into bankruptcy. Serious consequences! In the final hour, with debt payments looming, Congress finally agreed to the "Budget Control Act of 2011" — and the debt ceiling was raised.

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However, the BCA deal included these conditions - designed to slash the government's overall debt in half:

  • Temporary tax cuts implemented by President George W. Bush and a payroll tax holiday that President Obama implemented will expire January 1, 2013.
  • Government spending will be cut by $110 billion (half in the military and half elsewhere).
  • Federal emergency unemployment insurance, for those whose usual employment insurance benefits have run out, will stop.

These are a few of the measures that Mr. Bernanke groups into the fiscal cliff. It's worth noting that neither President Obama nor the House was thrilled with the BCA — it was merely a compromise deal that allowed the country to prevent a default on its debt. The hope was that the two parties could hammer out a better deal before the measures actually came into effect.

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But you know how it goes, people get busy… then the election got in the way… and before you know it, yikes… the fiscal cliff is just a few weeks away!

What does it mean for Americans?

Okay, a bunch of tax cuts will end and a bunch of government programs will have to be cut back. Boo-hoo, you say? Austerity is in style — just ask the Europeans, right?

What makes this situation a fiscal cliff, rather than a prudent debt reduction plan, are two things: (1) the impact on individual Americans and (2) the precarious nature of the US economy just barely recovering from the big recession of 2008-2009.

If the current tax cuts are allowed to expire, 90% of Americans will face higher taxes. Experts say that households earning between $40,000-$64,000 can expect their take-home pay to drop by nearly $2,000 per year. The Brookings Institution Tax Policy Center estimates that the average US household tax bill will rise by nearly $3,500.

That's some serious coin. You can imagine, if your household suddenly faced that kind of income shrinkage, how much your lifestyle would be affected. You would certainly think twice about eating out, taking holidays and going shopping. Your ability to make payments on your car loan or mortgage would become a lot tougher.

A sudden drop in spending would make businesses suffer, leading to more job losses and a sharp decline in GDP. In other words, a recipe for another recession.

And yet, the more the government borrows, the more unsustainable its debt load becomes. The country starts to look like a riskier investment and lenders demand ever-higher interest rates. The government will need to collect even more money from its citizens to finance its debt.

[More: Making a graceful Grexit: The Greek debt crisis explained]

Somehow, the US Congress has to figure out how to keep its economy going AND reduce its debt. And they need it do it — pronto.

What does it mean for Canadians?

We've all heard the old joke: when the United States sneezes, Canada catches a cold. So if our neighbor takes a Wile E. Coyote-like dash off a fiscal cliff, does that mean Canada will take a flying leap too?

According to economists at TD bank, the US GDP could drop by 3-4% if the fiscal cliff is not averted and consequently Canada would lose 1% off our own GDP. Our neighbor to the south is still our biggest trading partner and our export levels are still not back up to the level they were before the 2008-2009 recession.

While the Canadian economy did not suffer as much as the US during the recession, this was largely due to Canadian spending. Our household income-to-debt ratios have skyrocketed to 163%. But that spending has begun to slow down as we realize that our own personal debt levels are unsustainable.

Therefore, if the US economy stops spending and demand for our Canadian resources shrinks further — combined with less Canadian spending — well, as you can see, our own economy will be poised for a serious slowdown. Even the looming threat of the fiscal cliff is causing our dollar and Canadian bonds to bounce around rather anxiously.

What does it mean for the markets?

You may have noticed that the stock markets sank the day after the US presidential election in November. This was the market's way of expressing doubt that the Democrat President and Republican-dominated House can ever get along productively and come to a new and improved agreement before the January deadline.

Since the election however, messages have been mixed. Whenever President Obama or John Boehner, Speaker of the House, talk about making an effort to work together to avert the fiscal cliff, stock markets rise in approval. The Canadian dollar and our commodities also rise. Conversely, when any new warnings or fears over the possibility of another stalemate or political brinkmanship erupt, the stock markets, the loonie and commodities all slump with worry.

Between now and January, you can expect the seesaw to continue until some level of agreement is reached.  One thing you can count on: markets always respond better to certainty rather than doubt.

The silver lining

Many experts say that fears of a fiscal cliff are being exaggerated. The actual tax increases and spending cuts will not all go into effect immediately; they are in fact staggered for introduction over the course of 2013. So it's perhaps more of a declining slope than a sharp cliff. This gives the US Congress a bit of leeway — even if an agreement is not reached by January 1st, an agreement soon after could still remedy the situation.

Nevertheless, there is something about a deadline that focuses attention and encourages action. And if it takes a mild-mannered economist to shout out warnings of a fiscal cliff ahead, then maybe a little drama is just what the economic doctor ordered.

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