As in the eurozone, a sudden drag in demand would surely push the US into a recession

Franklin Roosevelt once said America had nothing to fear but fear itself. This statement can?t be more appropriate than describing the current state of the US economy. Relative to Europe, US short-term growth prospects are good, although the measure is much stingier nowadays.

Compared to almost everyone, except Canada and Australia, the US energy outlook is rosy. Yet, relative to its own standards of governance, the US has rarely been less capacitated. Markets will be first over the ?cliff?, if politicians don?t show real signs of compromise on taxes and spending cuts in the next several days. The ?fiscal cliff? is edging closer, with the White House and Republicans still far apart on the issue of taxes and Washington now shut down for the Christmas and New Year holidays. The cliff is the more than a $500 billion double-whammy to the economy through expiring tax-breaks and automatic spending cuts, provided Congress doesn?t act before January 1.

The Congressional Budget Office has estimated that while the economy would shrink at an annualised rate of 1.3% during the first half of next year if the cliff is not averted. However, growth could rebound to 2.3% in the second half of 2013.

The chances of going off the cliff are increasing, and could push the economy into recession, according to Congressional Budget Office projections. The markets are expecting a resolution, but the expectations have been lowered and many expect a smaller plan, which would do the minimum and offer little in the way of tax or entitlement reform. Since the time is short, many are now expecting to see a deal and votes in early January, but President Barack Obama believes he would still push to get a deal done by year end.

Next year we are likely to have an answer to the nagging governability question. Either Washington clinches a deal about the size of government and the purpose of the tax system that is helpful to US growth prospects, or the parties hit a stalemate and postpone the day of reckoning. There are three reasons to suppose they will kick the can down the road.

First, the immediate stakes are lower than many people think. In contrast to the eurozone, which is facing at least another two years of flat growth, the US economy is back on its feet. It may be limping and is unlikely to start running soon?most economists, including Ben Bernanke, believe America?s sustainable growth rate has fallen since the Great Recession. However, even if the US were to dip briefly off the cliff, the economy would probably still grow between 1% and 2% in 2013. Polls say the public would chiefly blame the Republicans for whatever slowdown ensued. But it is not as though the country would be in depression. And Republicans might bet the damage would have occurred early enough into the new Congress for the electorate to have forgotten it by the 2014 midterm elections. It would be a surprise if they could hammer out a sensible grand fiscal bargain in between.

Second, the gap between the parties?the chief cause of the last bout of brinkmanship of August 2011?has grown wider. According to voting patterns, the outgoing 112th Congress is the most polarised in modern US history. According to studies of the new intake, the 113th is to be even more split. It is not just a story of conservative Republicans replacing moderates?though that has been the chief driver of America?s polarisation. Democrats are also becoming more liberal. The once powerful centrist Democratic Blue Dog coalition has nosedived from 54 members in 2008 to just 15 next year. The term moderate Democrat is becoming almost as rare as its counterpart. Nor is the divergence confined to ideology. The parties also look different. According to Bloomberg, the share of white male Democrats in the 113th Congress is 47%?it fell below half for the first time. Meanwhile, 90% of GOP lawmakers are white males.

Third, the election on November 6 offered only a brief pause in America?s permanent electoral campaigning. With a short break for Thanksgiving, lawmakers on both sides have begun fund-raising in earnest for 2014. Moderates need to build up war chests now in order to pre-empt primary challenges. The jockeying for the 2016 Republican nomination has also begun. Among the big hopefuls is Paul Ryan, Mitt Romney?s former running mate, and the chairman of the House budget committee. Mr Ryan is the current darling of the anti-tax wing of the GOP. If he opposes a tax increase, it is probably dead-on-arrival. If he gives his blessing, he would damage his presidential chances. Mr Ryan could end up being the most pivotal figure in the game of chicken over the coming weeks.

If there is one thing at which Washington does not excel, it is self-deprecation. The city operates to a kind of Gresham?s Law, where self-importance drives out whatever humour is to be found.

The focus since the election has been fixed on whether the US will avoid the cliff. But remember that if a deficit-cutting deal is reached, it may not be all good news for equity investors. Declines in deficit spending must be balanced by declines in cash surpluses in other sectors. Corporate profits are likely to suffer if the fiscal deficit improves by more than 1% of gross domestic product. But the CBO estimates are far too conservative. The fiscal drag implied by going over the cliff would subtract about $1 trillion (6.3% of gross domestic product) from projected growth over the 18 months from January 2013. Given the consensus forecast for 2% growth next year, that leaves a growth rate of minus 2.2% for 2013. This calculation is consistent with estimates reported in October by the IMF.

An extant American liquidity trap explains why the recession would be so severe. Such a trap exists when interest rates are frozen at zero and cannot fall. It magnifies the negative impacts of austerity. Absent the trap, the drag on GDP from tighter fiscal policy is usually mitigated by falling interest rates. Interest rates tend to fall, as household and business incomes drop and demand for money and credit shrinks. Lower interest rates then boost private sector spending, partially offsetting the fiscal drag from higher taxes and government spending cuts.

But in a liquidity trap, with interest rates stuck at zero, there is no offset to the fiscal drag. In technical terms, the negative multiplier is larger than usual. The IMF has produced evidence that negative fiscal multipliers have indeed been larger than expected since the start of the financial crisis, which has coincided with interest rates falling close to zero and economies stuck in liquidity traps. The enhanced fiscal drag tied to austerity programmes such as those in Greece, Portugal and Spain must have come as a nasty shock. During 2010 and 2011 some European central bankers were arguing that the boost to confidence from cutting deficits would mean that austerity might actually stimulate those economies. It did not. Instead, in the absence of interest rate reductions, the drop in incomes engendered by austerity depressed tax receipts so much that the ratio of government debt-to-GDP has increased in southern Europe.

Three lessons emerge from the larger negative fiscal multiplier implied by America?s liquidity trap and from Europe?s sad experience with austerity. First, do not even think about going over the fiscal cliff. Even a ?half cliff??fiscal drag of 2.1% of GDP?would put the US economy in a recession for all of 2013. Second, don?t expect the Federal Reserve to offset fiscal drag. It can?t. Conventional monetary policy cannot stimulate spending, because the Fed cannot lower interest rates. Nor can quantitative easing because it is being undercut by a growing demand for liquidity as businesses and households confront uncertainty, ranging from fiscal cliff negotiations to healthcare revisions and a possible collapse of the euro. The third lesson applies to the design of fiscal tightening. If averting the fiscal cliff requires a Republican concession on tax rates for ?the rich? in exchange for entitlement reforms, the rise in such rates should be minimised?to 2 percentage points at most?by simultaneously reducing regressive tax allowances. Taxpayers with incomes of more than $250,000 will already start paying an extra 3.8% Medicare tax on all income from January 1, 2013. Any deal to avert the cliff is likely to be drowned out by bipartisan self-congratulation. It is unlikely to be deserved. The real test will come during the course of 2013. Having averted or temporarily gone over an entirely self-created cliff, Congress will still have to confront America?s long-term outlook?the ?fiscal abyss? that lies beyond the cliff.

Then during 2013, Congress should specify a decade-long programme to stabilise and then reduce the debt-to-GDP ratio, without hurting growth. That programme should include entitlement reform and fund phased reductions of marginal tax rates by further reducing allowances. There are thus issues unresolved including and beyond the ?fiscal cliff? which could keep stock markets on the edge in 2013.

The author is the CEO of Global Money Investor