There is a prize in this fiscal cliff saga but stronger US growth isn't it

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American fiscal policy could have been dreamt up by a Hollywood script writer.

Last summer, we had the “will they, won’t they” blockbuster over whether the US government would default for the first time. Now (Other OTC: NWPN - news) , just in time for Christmas, Washington has exceeded all expectations by delivering a sequel. And it has got a snappy title to boot.

We’ll get to the details of the fiscal cliff shortly, but it is first worth noting why US fiscal policy has lurched from drama to drama over the past two years.

Firstly, warring Democrats and Republicans have refined the lazy political habit of “kicking the can down the road” into a high art. The inability of President Barack Obama and both sides in Congress to reach a compromise over tackling America’s $16 trillion (£9.9 trillion) debt pile means that, like a weekend when no one claims the lottery prize, the stakes keep getting bigger.

Secondly, America’s politicians have invented these stomach-churning deadlines for themselves because financial markets haven’t imposed them. In sharp contrast to most other Western democracies since the financial crisis, America’s borrowing costs have remained stable and have not even threatened to create any sweaty palms in the US Treasury Department. Yes, the yield on the US 10-year government bond is above the record low of 1.39pc it reached in July, but it is still comfortably below 2pc.

Although politicians may have turned fiscal policy into a saga worthy of a major movie studio, the threat posed by the fiscal cliff is real enough. The term is shorthand for roughly $600bn of spending cuts and tax rises due to take effect at the turn of the year. If they are allowed to in their entirety, the Congressional Budget Office, a leading independent forecaster, believes the world’s largest economy will return to recession for the first time since 2009.

It would take an act of gross negligence on the part of politicians to allow it to happen. They will not. Despite their determination to shrink America’s debt, Republican politicians know that sending the US back into a downturn will be counterproductive as tax revenues would slide and unemployment benefits climb. At the same time, Obama is acutely aware that if the economy stalls, it is the occupant of the Oval Office who will own the recession.

The tortuous negotiations between Obama and John Boehner, the Republican leader in the House of Representatives, have thrown up the outlines of a deal that skirts the cliff. It will see both sides commit to about $1trillion in spending cuts and raising $1trillion in taxes over the next 10 years. If heading over the cliff is unlikely, exactly how it is avoided matters as America enters 2013 juggling the twin imperatives of strengthening the economic recovery and shrinking its debt.

For anyone concerned about the prospects for US growth next year, what we know so far about the likely deal carries mixed news. First (Other OTC: FSTC - news) the good bits. The largest part of the cliff comes from the expiration of tax cuts first handed to the US public by George W Bush in 2003. Should they all expire as scheduled on New Year’s Eve, economists estimate it will drain

about $200bn, or the equivalent of 1.2pc of US gross domestic product, from Americans’ pockets. Exactly who should have to pay more taxes has been the sorest point of division between Democrats and Republicans, with Obama arguing that any household earning more than $250,000 a year must fork out more. Republicans have tabled a threshold of $1m.

As the sides edge closer to a deal, it looks like the vast majority of Americans will be spared an increase in their income taxes. Economists argue that lifting taxes on lower and middle-income households typically inflicts a bigger blow to the wider economy because households in these brackets spend more of their earnings. It is why the likely extension of the emergency unemployment benefit, also due to expire at the end of the month, should be welcomed.

Those claiming the benefit, who have to have been out of work for six months, inevitably push the vast majority of their income straight back into the economy.

“For the same dollar amount, the hit on the economy of letting unemployment benefits go would be more damaging,” than other ways of raising revenue, said Greg Daco, an economist at IHS Global Insight.

The bad news is that an emergency cut in the tax that both employers and employees pay looks set to perish as part of the deal. Given the cut reduced the cost of hiring, economists fear it will prove a headwind in 2013. “It’s been viewed as one of the more stimulative measures,” says Mike Gapen, an economist at Barclays (LSE: BARC.L - news) .

With much of Europe in recession, Britain struggling and Asia slowing, how the US performs next year matters. There is a camp on this side of the Atlantic that believes once the uncertainty created by the fiscal cliff is removed, growth will surge.

Jamie Dimon, the chief executive of JP Morgan, is a member and told a conference last week that we could “have a booming economy in a couple of months”.

While there is evidence that the cliff has slowed business investment, it is far fetched to believe that a deal will be so transformative. The problem with the imagery of the fiscal cliff is that it tempts one to think in binary terms: there is either an awful outcome or a great one. The sobering truth is that however Washington avoids the cliff over the next fortnight or so, a deal will see the US embark on austerity at a national level properly for the first time since the crisis.

“There will be fiscal consolidation,” says Kevin Logan, chief US economist at HSBC (LSE: HSBA.L - news) . “That is coming. It’s a question of the degree and the form it will take.”

There is, though, a prize to be had for the US and the rest of the world from the fiscal cliff saga. And it will be evidence that America’s divided politicians at last realise intelligent compromise is required for the country to tread the tightrope between growth and austerity over the next four years.

We will know progress has been made when the next episode in US fiscal policy wouldn’t make it anywhere near a Hollywood film studio.