Under current laws, taxes will rise and government spending will fall at the start of 2013 by the equivalent of 5.1 per cent of GDP. This "could be devastating", says Rob Wood at Berenberg Bank. It would almost certainly plunge the economy back into recession. Economists hope the president can now reach a deal with the Republican-dominated House of Representatives to prolong the tax cuts and delay the spending cuts. Mr Wood expects a last-minute compromise which would limit the fiscal tightening to around 1 per cent of GDP.
This could give a big lift to the economy simply because it would remove a big source of uncertainty. Nick Bloom at Stanford University points out that such uncertainty depresses economic activity simply by making companies reluctant to invest or hire workers. He calculates that if policy uncertainty could return to its pre-2007 level, the US economy would create an extra 2.3m jobs. For this reason, say Aneta Markowska at Societe Generale, any deal could create "significant upside" for business investment.
This, however, is not certain. James Hamilton at the University of San Diego fears that some Congressmen would prefer to go over the fiscal cliff before reaching a deal because it would allow them to reframe their tax proposals. What look like tax rises relative to the current tax burden would become tax cuts relative to the post-cliff burden. Those Republicans who signed a pledge in 2011 to oppose tax rises could therefore more easily claim to have kept their promise if they agree a fiscal package next year rather than this.
This matters for shares because the fiscal cliff is also a dividend cliff. On current policy, the top tax rate on dividends will rise sharply next year. This would reduce companies' incentives to pay dividends, and increase the relative appeal to investors of 'growth' stocks which don't pay dividends.
Also, even those who expect an agreement to remove the fiscal cliff don't expect any agreement soon to solve the problem that US government debt could rise over the longer term. Mr Wood says he is "not optimistic" about a solution to this. While this isn't a pressing problem as long as bond markets are happy to lend to the US government at negative real interest rates, it could become one when borrowing costs increase.
Luckily, though, equity investors have history on their side. Since 1926, the US stock market has done much better under Democrat presidents than under Republicans.
