As worst euro fears fade, US fiscal cliff looms

The euro zone has stepped back from the brink of disaster for now, but the global economy could soon be staring into another abyss if US politicians fail to head off $600 billion in automatic austerity that all but guarantees a new recession.

The long-term fate of the single currency remains unclear, but nerves have calmed since the European Central Bank promised on September 6 to act as the buyer of last resort for Spanish and Italian bonds.

Now, exactly six weeks before the US general election, fiscal gridlock in Washington is coming back on the global economy's risk radar.

If opinion polls hold steady and prove accurate, President Barack Obama, a Democrat, will defeat Republican Mitt Romney on November 6.

The House of Representatives is likely to stay in the hands of the Republicans, who have a chance of seizing control of the Senate.

On the surface, with power split, that could make it harder to avert $600 billion in spending reductions and expiring tax cuts, equal to 4% of gross domestic product, that will kick in at the start of 2013 unless a deal is struck to shrink the US budget deficit by at least $1.2 trillion over the next decade.

"The level of political partisanship in Washington is higher than it's ever been, and that it is making it much harder to deal sensibly with some of the economic and other problems America is facing," said Xenia Dormandy, a senior fellow at Chatham House, a think tank in London.

"The American system is designed to have checks and balances and that's what's happening. But it does mean that in times like this, when strong responses are needed, they're not forthcoming," she added.

The consensus among US and other politicians, policymakers and businessmen at a recent conference organised by Oxford Analytica, another research group, was that Washington would avoid plunging off the fiscal cliff - or at least falling all the way down. But some were downright pessimistic that the political gulf could be bridged any time soon, with potentially ominous consequences for America's growth and credit rating.

One European economist said he feared America as a whole was becoming like California - a dynamic economy suffering from political sclerosis.

"The dysfunctionality of democracy in the United States is the most important problem America faces in coming years," he said.

To encourage a frank exchange of views, reporters were not allowed to identify the speakers at most of the conference sessions.

Brinkmanship, again
A North American former politician said the US political system had astonishing powers of renewal. Deadlock would not last forever.

But he said there was global disquiet that the logjam was preventing America from capitalising on its strengths in high-technology, science and advanced manufacturing.

"Brinkmanship is no way to run public policy," he said. Tightening on the scale envisaged is unprecedented in recent US fiscal history, and Federal Reserve Chairman Ben Bernanke has said the shock would imperil an already fragile economy.

The Congressional Budget Office has warned of recession. Indeed, slowly and quietly, Congress is groping for ways to dodge the cliff plunge by putting off its own deadline for most of the major year-end budget and tax decisions.

Compromise is also the scenario seen by a number of banks - though they do not rule out an initial, limited cliff dive to concentrate politicians' minds. Economists at Citi led by Nathan Sheets expect lawmakers to delay tax increases and to recast spending cuts, resulting in fiscal drag of about one percentage point and a relatively benign near-term growth outlook.

"Nevertheless, with general government debt already topping 100%, this leaves the US dangerously exposed to an abrupt loss of market confidence and a fiscal crisis as near-term debt continues to outrun GDP," they said in a study. HSBC reaches a similar conclusion.

On a muddling through scenario of some austerity and debt reduction, fiscal tightening would amount to 1.1% of GDP in 2013. But that would still leave the budget deficit in fiscal year 2013 at 6% of GDP, one of the highest on record, Kevin Logan, the bank's chief US economist, said in a report.

Trade policy, China
The prospect of continued political polarisation would seem to bode ill for the two candidates' promise to promote trade.

But a former State Department official noted that Obama managed last October to push through a trio of free trade agreements with Colombia, Panama and South Korea that had been bogged down for four years.

"If we're on stronger domestic ground we might see a flowering of free trade with bipartisan approval," she told the Oxford Analytica conference. On China, there was widespread scepticism that a President Mitt Romney would make good on his promise to punish China by declaring it a currency manipulator on his first day in office.

Doing so would antagonise a country that is the biggest holder of US Treasuries and is now America's third-largest export market, after Canada and Mexico.

Between 2000 and 2011, US shipments to China rose 542%, while exports to the rest of the world rose 81%, according to Andy Rothman, an economist at CLSA in Shanghai.

Like Romney, Obama has been tough on China during the campaign, launching a World Trade Organisation challenge against Beijing's subsidies on autos and car parts.

The two candidates are attuned to public opinion: the Pew Center found 59% of Americans regard China as an economic threat compared with 45% of Europeans. While 67% of Americans say that international business ties are good for the US economy, this was the lowest level of backing for trade among 21 countries surveyed by the Center in 2011.

The figure in France, a sometimes ambivalent supporter of free trade, was 83%.

"None of this will necessarily translate into protectionist actions by the next administration that could inhibit world growth," the Pew Center's Bruce Stokes said in an analysis. "But it does suggest that Washington's offensive efforts to promote trade my be met with public scepticism, while defensive actions may find public support."