11/27/12 – Edging Closer to the Cliff

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 27, 2012 11:41:46 AM

and tagged Fiscal Cliff, Politics and the Economy, Yesterday's News

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The fiscal cliff debate has shifted to some interesting ground. After a good start, with both sides sitting down and announcing that a deal was doable, there has been little visible action between the parties. There has, however, been quite a bit of activity within each party.

The internal debate on the Republican side has received more coverage. Many Republicans have indicated that they are open to more revenue and even conditionally willing to break the “no new taxes” pledge that has been a staple of Republican officeholders for decades. That battle is far from over, but recent press seems to show a definite trend among Republicans who are realizing that, with the newly reelected Obama and a greater number of elected Democrats in both legislative houses, the voting public has come down on the side of higher taxes.

Of course, the Republicans may be able to claim victory by reframing the “no new taxes” pledge to a “no higher tax rates” pledge, and this is what appears to be happening. By limiting deductions for the “rich,” their effective tax rates can be increased without actually increasing the marginal rates.

Both parties are publicly on board with this, to the extent that one of the most untouchable of all deductions—for mortgage interest—is at risk; see the story on page B1 of today’s New York Times (NYT), “A Tax Break Once Seen as Sacred Is Now Seen as Vulnerable.” With mortgage interest deductions under threat, it now seems that the revenue debate has moved, at least for the moment, from whether to raise revenue to how to do it and by how much.

As I have written before, the financial reality is that taxes have to go up, and the Republicans have finally made that leap. In exchange for this, though, the party is demanding that entitlements be reformed and spending—the other financial reality—be addressed. But the Democrats have not yet made this leap of their own.

On the front page of today’s NYT, “Efforts to Curb Social Spending Face Resistance” discusses how Democrats are facing an internal battle on their side of the compromise. Democrats also have to contend with various interest groups that want to incorporate their pet interests into any solution; an example appears on page A4 of last Friday’s Wall Street Journal (WSJ), “Higher Gas-Tax Idea Joins Fiscal Cliff Talks.” Although the Republican civil war is not over, it is at least well begun. The Democrats are just getting started.

As for the fiscal cliff negotiations as a whole, they appear to be progressing as well as can be expected. The principals are letting staff handle it—as they should in these early stages; ideas are floated in the press, generating much of the coverage we see; internal compromises are fought out quietly; and information that supports one side or the other is selectively leaked in an attempt to make a case to the public. For instance, “White House study warns of $200bn fall in consumption” on page 7 of today’s Financial Times.

Many of the public comments made by both sides have been relatively conciliatory, however, which is an encouraging sign. Even more positive, Treasury Secretary Tim Geithner has been named negotiator for the Democrats, as covered on page A4 of yesterday’s WSJ. He is one of the more credible negotiators that could have been selected and surely represents a bid by the Democrats for an actual solution.

Overall, the signs are still good, and market action reflects this. Hopefully, in the next few weeks, reality will bear out these positive signs.

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