December 2012

Everyone - including the financial markets - thought President Obama and the Republican leadership were on course to some kind of budget deal. It wouldn't be pretty, but they would find some way to delay or prevent most of the $600bn in tax rises and spending cuts that will otherwise hit the economy on 1 January.

Not any more. Right now, they don't seem to be on any path at all. The only good news for President Obama is that he is not going to get the blame. Against the odds, the events of the past few days have strengthened his hand relative to the Republicans, who were already disadvantaged by the result of the Presidential election.

What happens to the economy as a result of all this may well depend on how and whether he and his fellow Democrats decide to use that new power.

Remember how we got here: in the days after the election, many hoped that President Obama's victory would pave the way for Republicans to climb down in their opposition to all and any rise in taxes. And, to some extent, that has come true.

House Majority Leader John Boehner signalled early on that he was willing to sign up to a deal which would force wealthy Americans to pay more taxes - though by limiting their deductions rather than charging them higher rates. His 'Plan B' went further: it would not have renewed the Bush tax cuts for incomes over $1m.

Recent events are seen as having strengthened President Obama's position

Democrats considered that a terrible plan, which would really only raise taxes on the top 0.1% of households. Even the very richest would pay much less than under President Obama's plan, which would keep the Bush tax cuts for 'only' the first $250,000 of income. (On the Boehner plan, remember people earning more than $1m would keep paying the lower rates on any income below that amount).

There were lots of other reasons for Democrats to hate Mr Boehner's Plan B: it would have hit low income families by allowing benefits to expire for lots of unemployed people, and it would stall the President's plans for extra infrastructure investment.

For many - on either side of the aisle - that all made passing Plan B bad news for Democrats, and a 'no brainer' for the Republicans.

Either President Obama allowed it to go through, which would have given them nearly all of what they wanted on the tax side, without most of the spending on the Democrats' wish list. Or - much more likely - the President would veto it, making the Democrats look like the ones who were holding the economy to ransom.

But, as I said in my blog just after the election, a compromise that looks like a no-brainer to outsiders - and even, apparently, Mr Boehner - does not necessarily look like that to Congressional Republicans who have signed a pledge not to raise tax rates on anyone, ever.

As we learned, in a similar stand-off with President Obama in 2011, a lot of them actually meant it. And they haven't changed their mind as a result of the election, or the scary talk about the fiscal cliff.

What happens now? The short answer is not very much. Neither Congress nor the Senate are likely to do any real business now until after Christmas, meaning there is little chance of getting anything more than a very short-term stop-gap into the statute books by 1 January.

As I said at the start, the newly re-elected President already had the upper hand going into the negotiations; politically, he is in an even stronger position now. But Mr Boehner's decision to seek an alternative to the President's plan has soured many Democrats against making any more compromises. What happens now depends on whether President Obama's foot soldiers are as willing to play chicken with the recovery as Mr Boehner's troops seem to be.

The good news for the financial markets is that, as I have said before, the "cliff" is more of a slope. There's nothing to stop them reversing most of the damage from tax rises in the weeks after 1 January. Nothing, that is, except the dysfunctional politics which has made the slope so steep in the first place.

CET

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