What now with the “Fiscal Cliff?”

So I explained what the fiscal cliff is and why it is bad, but what will ultimately happen?  I have no idea, trying to figure out what a bunch of politicians are going to decide seems like a fool’s game.  Who can predict that?

Still, what we can try and do is estimate probabilities.  Now, I am not a forecaster, but I can give you the good news – the CBO says the forced austerity would probably throw the economy into recession.

Why is this good news?  Well the severity of going over the“fiscal cliff” is severe, so my thought is reason will dictate the discourse and if reason fails there is the insurance that these politicians like to keep their jobs.  I would actually bank more on the latter.   

Further, the two big items are the Bush tax cuts expiring and the “sequester”, there seems like a natural compromise here.  Republicans get the tax cuts, Democrats get to push back the automatic spending cuts.  Maybe the stimulus measures don’t get renewed, but hopefully the Bush tax cuts staying and "sequester" leaving will be enough to keep this 2% growth train moving!

Here is how Goldman Sachs econ team handicaps it:

1. 35% chance of temporary expiration of growth policies in 2013
2. 40% chance of short-term extension of growth policies with longer-term solution in later 2013
3. 20% chance of extension of growth policies for more than a year
4.  5% chance of “grand bargain” of fiscal and tax reform

The problem with the above (as with Europe) is that temporary measures are just that and create even more uncertainly.  Still, the above paints a 65% chance of outcomes I believe would be intermediately (through Q2 2013 maybe) good for the market, of course absent any exogenous shocks.

At the end of the day, I think the “fiscal cliff” big risk parallels another one of my big risks – Europe.  That is to say, the severity of the situation should yield at least a semi-positive result (I hope).  Still, the risks are large, real, and should be met with caution.  My other big risks are much harder to handicap – war Iran (seems low, but who knows) and a Chinese hard landing (black box).

Why the “Fiscal Cliff” is Bad

I have covered many times why I am against austerity at the present moment.  In fact, it was one of my big risks to economy and market going forward.

The problem with the fiscal cliff and the austerity it will bring – the same problem Ben Bernanke speaks of – is that what picks up that slack?  If GDP is comprised of consumption + investment + net exports + government spending and government spending is cut, which one of the other 3 is going to increase to offset that?

I don’t model GDP, but the bullets below should give you an idea of the growth versus austerity trade off:

• The Congressional Budget Office reckons that the combined effects of the “sequester” and the expiring tax cuts would add up to 3.6% of GDP in fiscal 2013.  (Source 3)
• David Greenlaw of Morgan Stanley, which puts the total effect at almost $700 billion at an annual rate, argues that the calendar-year impact is at around 5% of GDP.  (Source 3)
• David Rosenberg estimates the drag equates to roughly 4% of GDP from reduction of those tax benefits to spending.  (Source 1)
• According to Goldman Sachs, the total of amount of dollars the US government will be taking out of the economy is about $600 billion.  (Source 2)  

Such reductions have happened in the past, but with poor results:

• The last two times, 1960 and 1969, that there was a fiscal retrenchment of the same magnitude both ended in recessions. (Source 1)
• In 1968, when individual, corporate, excise and payroll taxes collectively rose by the equivalent of 3.1% of GDP, mostly to pay for the Vietnam War and to damp down inflation. The next year, the economy fell into recession.  (Source 3)

Now, the flip side would argue that at least we will reduce the budget deficit, but who cares?  At the expense of growth this seems silly.  Further:

• Austerity hasn’t worked for Europe.  Take a look at Spain, where austerity is taking place.  There GDP is falling and unemployment is at 24% and rising.  Further, the benefits austerity should have brought aren’t happening as bond yields are increasing and the deficit is growing.
• Why do we need to cut the deficit now?  Interest rates are low, very low, inflation is tame, and GDP growth is still sluggish.  What exactly is the risk at the present moment?

In the last post I will discuss the probabilities of what will ultimately happen with the “fiscal cliff”.

Source 1 – Lance Roberts and David Rosenberg.

Source 2 – Walter Kurtz and Goldman Sachs.

Source 3 – The Economist. 

What is the “Fiscal Cliff?”

I decided to do this series because a friend of mine asked why Fed Chairman Ben Bernanke was warning Congress about a “fiscal cliff.”  Coincidentally that afternoon I found an article discussing the “fiscal cliff” and its ramifications, so I decided to do some digging.

The “fiscal cliff” refers to the end of many stimulus tax measures (payroll-tax cut, investment tax credit, enhanced unemployment insurance), the Bush tax cuts, and automatic spending cuts called “sequester” at the end of 2012.  It is automatic austerity.  Here is a rundown:

• Tax Increases
• Under status quo at the end of 2012 roughly 42 tax benefits will expire at the end of 2012.  (Source 1)
• The 2001 and 2003 tax cuts are set to expire. This includes tax rates on those making over $250K as well as qualified dividends and in particular the 15% rate on long term capital gains.  (Source 2)
• The Payroll tax cut will expire at the end of 2012, increasing from 4.2% back to 6.2%.  (Source 2)
• The Alternative Minimum Tax (AMT), currently at 28% for those filing jointly with incomes of $74K or greater, will drop down to $45K.  (Source 2)
• Numerous temporary research and development tax benefits to corporations will expire.  (Source 2)
• Spending Cuts
• Automatic, across-the-board cut in domestic and defense spending, called the “sequester”, takes effect, cutting about $100 billion from government spending next year. (Source 3)
• Unemployment benefits for workers who have exhausted the standard 26 weeks of benefits will be phased out. (Source 2)
• At the end of the year the infamous debt limit will hit again, potentially forcing further cuts. (Source 2)

In my next post, I will discuss why this is bad.

Source 1 – Lance Roberts and David Rosenberg.

Source 2 – Walter Kurtz and Goldman Sachs.

Source 3 – The Economist.