U.S. runs out of road as fiscal cliff looms

LONDON Mon Dec 24, 2012 12:31am IST

LONDON (Reuters) - The wheels could come off the U.S. economy even before it has shifted out of second gear unless politicians reach a last-minute deal to avoid $600 billion in tax rises and spending cuts that kick in next month.

The rest of the world would be unable to avoid the pile-up if America does fly off the so-called fiscal cliff.

That is why, even in a holiday-shortened week, eyes will be peeled for signs that Democratic President Barack Obama and his divided Republican opponents can bury the hatchet.

The White House on Friday tried to rescue the stalled talks, but there was little headway to resolve what Alan Blinder, an economics professor at Princeton University, called the biggest near-term risk facing the global economy.

Seen from abroad, U.S. policymakers were looking "clownish", the former vice-chairman of the Federal Reserve said: "This will do us a tremendous amount of damage."

Until last Thursday, markets had assumed a compromise would be struck, averting the risk of a relapse into recession. The slow-motion car crash had been so well signaled that surely the drivers would swerve in time?

But after Republicans abandoned a fix proposed by House of Representatives Speaker John Boehner, businesses and households head into the year-end knowing the clarity they crave on tax and spending plans could be weeks away.

"The longer uncertainty persists, the greater the negative impact on the economy," Lewis Alexander, chief U.S. economist at Nomura, told clients.

"It may take the imminent threat of a breach of the debt limit in February, or March at the latest, to force an agreement," he added, referring to the Congressional approval that the Treasury will need to extend its borrowing authority.

THE CRASH HEARD AROUND THE WORLD

By sapping consumer confidence, the political brinkmanship could already be enough to sap short-term U.S. growth.

If America then does tumble over the cliff for more than a few days, triggering fiscal tightening that could reach 4 percent of GDP, the repercussions would be felt around the world via trade and financial links.

"If our economy goes into a recession, especially a serious recession, a deep recession, that's going to hit imports from the rest of the world. And to the extent that it messes up financial markets, that has a contagion effect," said Martin Feldstein, an economics professor at Harvard University.

Like Blinder, he was speaking on a conference call organized by Foreign Affairs magazine.

Indeed, the resulting turbulence in financial markets could end the period of relative calm enjoyed by the euro zone, said Christian Schulz, an economist at Berenberg Bank in London.

Failure to put the U.S. budget on a more sustainable path could well crush hopes that the world's largest economy is finally shaking off the effects of the financial crisis and returning to a path of steadier if not spectacular growth.

Credit Suisse on Friday raised its forecast for fourth-quarter gross domestic product growth to an annualized pace of 1.8 percent from 1.1 percent after consumer spending in November rose at the briskest rate in three years.

HOUSING RECOVERY

A recovery in housing is an increasingly important motor of growth, and figures on Thursday are expected to show new home sales rose to 380,000 in November from 368,000 in October, according to economists polled by Reuters.

Two of the top trading recommendations for 2013 by economists at Goldman Sachs are premised on a deepening housing market recovery. Existing homes changed hands in November at the quickest pace in three years, while confidence among U.S. home builders rose to a 6-1/2-year high in December.

Edward Jamieson, chief investment officer in Franklin Templeton's equity group, said housing was benefiting from record-low interest rates, a gradual reduction in household debt and significant pent-up demand.

"Higher home prices have also helped reduce the number of individuals with negative equity in their homes while also providing a strong wealth effect, which we think bodes well for continued improvement in the housing sector," he said in a report.

That markets in the last days of 2012 should be held hostage to events in Washington is fitting in one sense: this has been a year in which politics has shaped economic developments more than ever.

In the euro zone, a commitment by paymaster Germany to keep bailing out backsliding Greece, building on a pledge by European Central Bank President Mario Draghi to do whatever it takes to preserve the euro, largely allayed market doubts about the imminent disintegration of the single currency.

In Japan, Prime Minister-elect Shinzo Abe, whose cabinet will be sworn in on Wednesday, campaigned on a platform of more aggressive monetary and fiscal policy to jolt the economy out of two decades of anemic growth and gently falling prices.

The yen has weakened and Japanese stocks have risen in response even though many are skeptical that Abe will introduce the reforms Japan needs [ID:nL4N09V1BK].

The Bank of Japan, sensing which way the political winds are blowing, duly relaxed policy last week, and inflation figures on Friday are likely to reinforce expectations that there is more to come from the central bank.

Economists polled by Reuters expect core prices to have fallen by 0.1 percent nationwide in the year to November and by 0.5 percent in Tokyo in the year to December.

"We expect quantitative easing to continue aggressively in the first half of 2013, especially after a new governor takes the helm from the April 26 monetary policy meeting," Izumi Devalier, an economist with HSBC, wrote in a report.

(Reporting by Alan Wheatley; Editing by John Stonestreet)

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