Mrunalhttp://mrunal.

org

[Economy]FiscalCliff:Meaning,Reasons,
ImplicationsonUSandIndianEconomyexplained
PostedByMrunalOn24/11/2012@10:15pmInEconomy|71Comments

WhatwasSubprimecrisis?
WhatwasUSGovernmentsresponsetoSubprimecrisis?
WhatisFiscalcliff?
WhyisFiscalcliffbadforUSEconomy?
WhatwillbetheEffectofFiscalCliffonIndia?
FiscalCliff=newkidinthetown.Hisparentsare(1)FiscalDeficitand(2)SubPrimeCrisis.
Nowmeethismom,SubprimeCrisis.

WhatwasSubprimecrisis?
Subprimecrisisisalsomotherofallproblems:LIBOR,Eurozoneetc.(atleastpartially).
Yourerunningabank/NonBankingFinancialcompanythatgivesloans,andImbasicallya
loserwhodoesnthavetheaukaat(capacity)torepayanyloans.
Yet,You(AmericanBank)givemeloanof$20,000,AndIgiveyoupapersayingifIdont
payback,youcantakeawaymyhouse.Thisismortgage.
Waitaminute,ifIdonthavethecapacitytorepaytheloan,thenwhythehellareyou
givingmealoaninthefirstplace?Well,Tworeasons
BanksdecideLoaninterestratebasedonapersonscreditworthiness.Soinmycaseyou
candemandhigherinterestrate=goodforyou.
Yourealsospeculatingthatinfuturetherealestatepriceswillincrease,soevenifIcant
repaytheloan,youcanattachmyhouseandsellitofftorecoveryourloan.
Thus,itsawinwinsituationforyouwhetherIpaybacktheloanornot,youregoingto
makegoodprofit.

Now,Backtothetopic
Likethis,yougave$20,000loanseachto5unworthypeople=yourinvestmentis1lakh
dollars.
Nowrepackthosemortgagepapers(security)inanewfileandmakeanewsecuritypaper
anyonewhogivesme$1,50,000,Illgivehimmortgagepapersof5houses=thisis
derivativeproduct.(Becauseitderivesitsvaluefromsomeotherthing)
See?Youaremakingprofitof$50,000andyoudontevenhavetobotheraboutEMI
payments,interestratesanymore.
Suppose3rdguyboughtsuchderivativepapersandafterfewmonths,herepacksthem
makesanotherderivativeproductandsellitto4thguy.
Suchpapersareonesortofasset(becauseyoucangetmoneybysellingittosomeone.)
butasyoucansee,inabovecases,peoplearenotcreatinganynewasset,theyjustkeep
repackingandresellingsamestuffoverandovertodifferentpeople.Soyoureblowingan
assetbubble.
Afterfewmonths,I,thebottomguyinfoodchain,refusetopayloaninstallments(EMIs),
andItellthe4thguytotakeawaymyhouse(mortgage).
Fourthguytakesawaymyhome,butsincebanksgaveloantosomanyunworthypeople,
thereisoversaturationoroveravailabilityofhousesforsaleintherealestatesector.So
nooneisreadytopayyoueven$5000forthathouse.=Thisistoxicassetyourasset
bubbleisburst.
Thebanks,pensionandinsurancefundmanagersofEuropehadalsoinvestedinthis
game.Theyalsolost.Sointhatway,SubprimecrisisplayedaroleinfutureEurozone

crisis.
AbankofLondonnamedBarclayalsolostmoneyinthisgame,thatledtoLIBORcrisis.
^Thisisjustacrudeexplanationofwhathappenedinsubprimecrisis.Otherwisethe
actualcrisiswasresultofmanylayersofrefinedandsophisticatedloanandinvestment
productsinterlinkedwitheachother.
Anyways,theSubPrimecrisishadnegativeeffectoneverysector.
Stockmarketcrashed,Companiesstarteddismissinglocalstaff(especiallythosebanksand
mortgagecompanies).
Ifparentswereworkinginsomeprivatecompany,lostjobsortheirsalarywasreduced=
theydnothiremaidsorbabysittersanymore,theyllbuylessclothesandtoysfortheir
kids,theyllnotgotosomeholidayresortduringvacations.Soindirectlymanysectorsget
affected.
Moreunemployment=lessproductdemandedbythoseunemployedfamilies=evenmore
factoriesclosedown=evenmoreunemployment.Cyclegoeson.

ButwhyisitcalledSubprimecrisis?
Ifapersonhasfullcapacitytorepayloan,wecallhimprime.ThereforeImsubprime
becauseIdidnothavefullcapacitytorepaytheloan,mycreditratingwasbad.Yetyou
gavemeloanandranintotrouble=subprimecrisis.

USGovernmentsresponsetoSubprimecrisis?
USGovernmenthasthingslikeSocialSecurity,unemploymentallowance,foodstampsetc.
totakecareofthosejoblessfamilies.
PresidentObamastartedsomefederalconstructionprojects(roads,bridgesetc.)tocreate
employment.
Governmentalsoboughtthosetoxicassetstorescuethebanks.
TheFeds(RBIofUSA),decreaseditslendingratessootherbankscouldborrowatalmost
0%interestratefromtheCentralBankandthengivecheaploanstoneedypeopleand
businessmen.
Gaveincometaxcutstoworkers.Sotheycansaveatleast$1000fromtheirsalaryor
profit.
Samewaytaxbenefitstoprivatecompanies,Iftheyinvestmoneyinresearch
developmentetc.
^PresidentObamatookthesestepstoincreasemoneyinthehandsofAmericanpeople,so
theycangooutforshopping=demandofmoreproductsandservices=moreemployment
couldbecreated.
Butofcourse,moneydoesntfallfromsky.
Givingtaxcutstoworkersandcompanies=incomingmoneyreducedfortheGovernment.
Givingunemploymentallowancetojoblesspeople=outgoingmoneyincreased.
+dailyhugeexpensesforkeepingarmyinIraqandAfghanistan=outgoingmoneyalready
high.

Youalreadyknowwhenoutgoingmoneyishigherthanincomingmoney,itleadstofiscal
deficit.
Fiscaldeficitisabigpotholeintheroadtocountrysprosperity.Thispotholecanbefilled
withcashonly.Ifthispotholekeepsincreasinginsizethenitllleadtoverybadeffectson
economy.
So,PresidentObamahadplannedsomethingsinadvancetoincreaseincomingmoneyand
decreaseoutgoingmoneyfortheGovernment.Theseplansare:
Mostofthetaxcuts,taxbenefitsgiventopeoplewillberemovedfrom1stJanuary2013.
Forexample,earlierthepeopleweregiventaxcutsiftheyadoptedachild,investedmoney
inchildrenscollegeeducationplans,orbusinesshousesinvestedinresearchand
Developmentetc.Allthatwillexpirefrom1stJanuary2013,thustheyllhavetopayhigher
taxes.
ManyofGovernmentsponsoredprogramsinspaceresearch,militaryresearch,lengthy
unemploymentallowancesetc.willbeeitherpaused,reducedorshutdownfrom2013.
(Morethan900billiondollarssavedattheendof2013)
Ifthingsgoin^thisway,USGovernmentwillearn4trilliondollarsinnext10years.
Thatllcoverupmostofitshugefiscaldeficitsandpastmistakes.(i.e.buyingtoxicassets,
moneywastedonIraqAfghanistanandmostimportantlyPakistan).
Oksoundswellandgood,but

WhatisfiscalCliff?
Americaneconomywasgoingthroughbadphaseduetosubprimecrisis.
SoPresidentObamahadtogivestimulustoboostthiseconomy(taxcutstocompanies,
buyingtoxicassetsfrombanks=examplesoffiscalstimulus.)
FiscalStimulusaresimilartoSteroids.Ifanathletetakessteroids,itwilltemporary
improvehisperformanceandtakehimtowardsthepeakperformance.

Butonceyoustopgivinghimsteroids,hisperformancewillsuddenlydecline.Itwillfeel
likefallingoffacliff.Observethisgraph:

WhatisFiscalDeficit?
Fiscalclifftermreferstomorethan$500billionintaxincreasesandacrosstheboard
spendingcutsscheduledtotakeeffectafter1stJanuary2013.
Manyeconomistssaythesenewtaxesandspendingcutswouldbetoomuchdeficit
reduction,toosuddenly,foraweakeconomy.Itllleadtoaneconomicrecession.

WhyisFiscalcliffbadforUSEconomy?
Whenpeoplehavetopaymoretaxes=lessmoneyintheirhands=lessmoneytospendon
cinemaandChristmasvacations=lessdemandofproducts=notgoodforeconomy.
WhenGovernmentreducesresearchinspace,militaryprograms=manypeopleaffected
directlyorindirectly.E.g.lessfundsforspaceresearch=lessdemandforelectronic
instruments,metals,penpencilrubberrequiredinthoseprograms.
Again,IfparentswereworkinginsomeGovernmentresearchprogram/privatecompany,
lostjobsortheirsalarywasreduced,theydnothiremaidsorbabysittersanymore,theyll
buylessclothesandtoysfortheirkids,theyllnotgotosomeholidayresortduring
vacations.Soindirectlymanysectorsgetaffected.
IfPresidentObamasplaniscarriedout,then
MiddleclassfamiliesofUSA,willhavetopayaverage$2000moreintaxeseveryyear.And
$2000isabigamountgiventhatmanypeopleinUSAdontearnmorethan$40,000a
year.Soimaginethereductionintheirpurchasingpower.
Overall,Americanpublicwillhavetopay$500billionmoreintaxes.
Morethan10lakhpeoplewillbecomejobless.
^Thesenumbersvaryfromsitetosite,ifitsaproRepublicanpartynewspaperorexpert
theydsay20lakhAmericanwillbecomejobless,butsomeotherProdemocraticparty
newspaperoranalystwouldsayonly7lakhwillbejobless.

Anyways,Thepointis,AmericanHouseholdsandbusinessmenareaccustomed(used)toa
certainwayofspendingandsavinghabitsinpastfouryearsandObamaplanwillbreak
thatstatusquo=notgoodforeconomy,atleastfortheshortterm.Itllleadtoadecline
inGDP.
Observethisgraph

EffectofFiscalCliffonIndia?
IfAmericanconsumershavelessmoney=theybuyless=notgoodforIndianexporters
(especiallypolisheddiamonds).
ManyAmericancompaniesoutsourcetheirresearchanddevelopmentworktoIndia,
particularlypharmaceuticals(clinicaltrialsofdrugs),software,engineering.IfObama
removesthetaxbenefitsgiventothem(+consumerdemandalreadydown)=theylleither
delaypayments,cancelorrenegotiatethecontractsgiventotheIndiancompanies.
IfAmericanCorporatehavetopayhugetaxes@home,andconsumerdemandisalready
low,theylltrytoconcentratemoreonIndiaandotheremergingeconomiestogetnew
customers(Retail,Aviation,Pensioninsurance)=MoreFDImaycometoIndia.
Americansalreadyburnedtheirhandsinsharemarketandrealestate,ifthisfiscalcliff
leadstorecession,theyllparktheirmoneyinGOLD=demandofgoldincreased=gold
becomesevenmoreexpensive=biggerCurrentAccountdeficitforIndia(becausewetoo
lovegold)=Rupeeweakensagainstdollar,becausewhenweimportgold,wevetopayin
dollars=wevetopaymorerupeestobuysameamountofcrudeoil=petrolpriceincrease
=inflation.
Ref:
EspeciallythankfultoMr.KenWilsonforhisfiscalcliffgraphs.

ArticleprintedfromMrunal:http://mrunal.org
URLtoarticle:http://mrunal.org/2012/11/economyfiscalcliffmeaning
reasonsimplicationsonusandindianeconomyexplained.html
Copyright2014Mrunal.Allrightsreserved.