[Economy] Fiscal Cliff: Meaning, Reasons, Implications on US and Indian Economy explained

1. What was Subprime crisis?
2. What was US-Government’s response to Sub-prime crisis?
3. What is Fiscal cliff?
4. Why is Fiscal cliff bad for US Economy?
5. What will be the Effect of Fiscal Cliff on India?

Fiscal Cliff= new kid in the town. His parents are (1) Fiscal Deficit and (2) Sub-Prime Crisis.
Now meet his mom, Subprime Crisis.

What was Subprime crisis?

Subprime crisis is also mother of all problems: LIBOR, Eurozone etc. (atleast partially).

1. You’re running a bank/Non-Banking Financial company that gives loans, and I’m basically a loser who doesn’t have the aukaat (capacity) to repay any loans.
2. Yet, You (American Bank) give me loan of $20,000, And I give you paper saying “if I don’t pay back, you can take away my house.” This is mortgage.
3. Wait a minute, if I don’t have the capacity to repay the loan, then why the hell are you giving me a loan in the first place? Well, Two reasons

1. Banks decide Loan interest rate based on a person’s creditworthiness. So in my case you can demand higher interest rate=good for you.
2. You’re also speculating that in future the real-estate prices will increase, so even if I can’t repay the loan, you can attach my house and sell it off to recover your loan.

Thus, it’s a win-win situation for you whether I pay back the loan or not, you’re going to make good profit.

Now, Back to the topic

1. Like this, you gave $20,000 loans each to 5 unworthy people= your investment is 1 lakh dollars.
2. Now repack those mortgage papers (security) in a new file and make a new security paper “anyone who gives me $1,50,000, I’ll give him mortgage papers of 5 houses” = this is derivative product. (Because it derives its value from some other thing)
3. See? You are making profit of $50,000 and you don’t even have to bother about EMI payments, interest rates anymore.
4. Suppose 3rd guy bought such derivative papers and after few months, he repacks them- makes another derivative product and sell it to 4th guy.
5. Such papers are one sort of ‘asset’ (because you can get money by selling it to someone.)
6. but as you can see, in above cases, people are not creating any ‘new asset’, they just keep repacking and reselling same stuff over and over to different people. So you’re blowing an ‘asset-bubble’.
7. After few months, I, the bottom guy in food chain, refuse to pay loan-installments (EMIs), and I tell the 4th guy to take away my house (mortgage).
8. Fourth guy takes away my home, but since banks gave loan to so many unworthy people, there is over-saturation or over-availability of houses for sale in the real estate sector. So no one is ready to pay you even $5000 for that house. = This is ‘toxic asset’ your asset bubble is ‘burst’.
9. The banks, pension and insurance fund managers of Europe had also invested in this game. They also lost. So in that way, Subprime crisis played a role in future Eurozone crisis.
10. A bank of London named Barclay also lost money in this game, that led to LIBOR crisis.

^This is just a crude explanation of what happened in sub-prime crisis. Otherwise the actual crisis was result of many layers of refined and sophisticated loan and investment products interlinked with each other.

• Anyways, the Sub Prime crisis had negative effect on every sector.
• Stock market crashed, Companies started dismissing local staff (especially those banks and mortgage companies).
• If parents were working in some private company, lost jobs or their salary was reduced= they’d not hire maids or babysitters anymore, they’ll buy less clothes and toys for their kids, they’ll not goto some holiday resort during vacations. So indirectly many sectors get affected.
• More unemployment= less product demanded by those unemployed families=even more factories close down=even more unemployment. Cycle goes on.

But why is it called “Sub-prime crisis”?

If a person has full capacity to repay loan, we call him “prime”. Therefore I’m ‘subprime’ because I did not have full capacity to repay the loan, my credit rating was bad. Yet you gave me loan and ran into trouble= sub-prime crisis.

US-Government’s response to Sub-prime crisis?

1. US Government has things like Social Security, unemployment allowance, food stamps etc. to take care of those jobless families.
2. President Obama started some federal construction projects (roads, bridges etc.) to create employment.
3. Government also bought those toxic assets to rescue the banks.
4. The Feds (RBI of USA), decreased its lending rates so other banks could borrow at almost 0% interest rate from the Central Bank and then give cheap loans to needy people and businessmen.
5. Gave income tax cuts to workers. So they can save at least $1000 from their salary or profit.
6. Same way tax-benefits to private companies, If they invest money in research-development etc.

^President Obama took these steps to increase money in the hands of American people, so they can go out for shopping = demand of more products and services= more employment could be created.

But of course, money doesn’t fall from sky.

1. Giving tax-cuts to workers and companies= incoming money reduced for the Government.
2. Giving unemployment allowance to jobless people= outgoing money increased.
3. +daily huge expenses for keeping army in Iraq and Afghanistan= outgoing money already high.

You already know when outgoing money is higher than incoming money, it leads to fiscal deficit.

Fiscal deficit is a big pothole in the road to country’s prosperity. This pothole can be filled with cash only. If this pothole keeps increasing in size then it’ll lead to very bad effects on economy.

So, President Obama had planned some things in advance to increase incoming money and decrease outgoing money for the Government. These plans are:

• Most of the tax-cuts, tax-benefits given to people will be removed from 1^st January 2013.
• For example, earlier the people were given tax-cuts if they adopted a child, invested money in children’s college education plans, or businesshouses invested in research and Development etc. All that will expire from 1^st January 2013, thus they’ll have to pay higher taxes.
• Many of Government sponsored programs in space research, military research, lengthy unemployment allowances etc. will be either paused, reduced or shut down from 2013. (More than 900 billion dollars saved at the end of 2013)

If things go in ^this way, US Government will earn 4 trillion dollars in next 10 years. That’ll cover up most of its huge fiscal deficits and past mistakes. (i.e. buying toxic assets, money wasted on Iraq-Afghanistan and most importantly Pakistan).
Ok sounds well and good, but

What is fiscal Cliff?

• American economy was going through bad phase due to sub-prime crisis.
• So President Obama had to give stimulus to boost this economy (tax-cuts to companies, buying toxic assets from banks= examples of fiscal-stimulus.)
• Fiscal-Stimulus are similar to Steroids. If an athlete takes steroids, it will temporary improve his performance and take him towards the peak performance.
• But once you stop giving him steroids, his performance will suddenly decline. It will feel like falling off a cliff. Observe this graph:

What is Fiscal Deficit?

1. Fiscal cliff term refers to more than $500 billion in tax increases and across-the-board spending cuts scheduled to take effect after 1^st January 2013.
2. Many economists say these new taxes and spending cuts would be too much deficit reduction, too suddenly, for a weak economy. It’ll lead to an economic recession.

Why is Fiscal cliff bad for US Economy?

• When people have to pay more taxes= less money in their hands = less money to spend on cinema and Christmas vacations= less demand of products= not good for economy.
• When Government reduces research in space, military programs = many people affected directly or indirectly. E.g. less funds for space research = less demand for electronic instruments, metals, pen-pencil-rubber required in those programs.
• Again, If parents were working in some Government-research program/ private company, lost jobs or their salary was reduced, they’d not hire maids or babysitters anymore, they’ll buy less clothes and toys for their kids, they’ll not goto some holiday resort during vacations. So indirectly many sectors get affected.

If President Obama’s plan is carried out, then

1. Middle class families of USA, will have to pay average $2000 more in taxes every year. And $2000 is a big amount given that many people in USA don’t earn more than $40,000 a year. So imagine the reduction in their purchasing power.
2. Overall, American public will have to pay $500 billion more in taxes.
3. More than 10 lakh people will become jobless.

^These numbers vary from site to site, if it’s a pro-Republican party newspaper or expert- they’d say 20 lakh American will become jobless, but some other Pro-democratic party newspaper or analyst would say only 7 lakh will be jobless.

• Anyways, The point is, American Households and businessmen are accustomed (used) to a certain way of spending and saving habits in past four years and Obama plan will break that status quo = not good for economy, at least for the short term. It’ll lead to a decline in GDP.
• Observe this graph

Effect of Fiscal Cliff on India?

1. If American consumers have less money = they buy less= not good for Indian exporters (especially polished diamonds).
2. Many American companies outsource their research and development work to India, particularly pharmaceuticals (clinical trials of drugs), software, engineering. If Obama removes the tax-benefits given to them (+consumer demand already down)= they’ll either delay payments, cancel or renegotiate the contracts given to the Indian companies.
3. If American Corporate have to pay huge taxes @home, and consumer demand is already low, they’ll try to concentrate more on India and other emerging economies to get new customers (Retail, Aviation, Pension-insurance) = More FDI may come to India.
4. Americans already burned their hands in share-market and real-estate, if this fiscal cliff leads to recession, they’ll park their money in GOLD = demand of gold increased= gold becomes even more expensive = bigger Current Account deficit for India (because we too love gold) = Rupee weakens against dollar, because when we import gold, we’ve to pay in dollars= we’ve to pay more rupees to buy same amount of crude oil = petrol price increase = inflation.

Ref:
Especially thankful to Mr. Ken Wilson for his fiscal cliff graphs.