The Independent Market Observer

12/3/12 – On the Other Hand . . .

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Dec 3, 2012 10:21:29 AM

and tagged Fiscal Cliff, Politics and the Economy

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For the past couple of weeks, I have been writing about how I think, ultimately, we will not go over the fiscal cliff. I have based my views on the need for both parties—for their own good and for the good of the country—to actually compromise and solve the problem.

And the need for some sort of deal is increasingly apparent, as I believe, based on the facts at hand, that the damage done to the economy may be well in excess of the 4 percent of GDP that the actual tax increases and spending cuts amount to. About two-thirds of that 4 percent is made up of tax increases; the rest is spending cuts. Economic studies have shown that the multiplier for tax increases is between 2 and 3, while that of spending cuts is between 1 and 2. Combined, using a multiplier of 2.5 for the tax increases and 1.5 for the spending cuts, we might reasonably assume a 7-percent to 8-percent hit to GDP.

Given that we are now growing at roughly 2 percent to 2.5 percent, that means a potential recession of –5 percent to –6 percent. These are rounded, approximate numbers, since no one really knows the exact details. The idea is that the impact will be worse than the mild recession of –1 percent to –2 percent that the raw GDP-cut figure would suggest.

But these numbers (–5 percent to –6 percent) don’t actually tell us much, so let’s put them in context. This level of recession would be worse than anything we have seen since the early 1980s—except the most recent one, and it is only slightly less severe than that. So we could be looking at the Great Recession, Part 2. In addition, Congressional Budget Office estimates suggest that the unemployment rate—the U-3 rate, which, to be honest, is not the best indicator—would spike back to above 9 percent.

Because of the potential economic consequences, I still believe both sides have an incentive to close a deal. That said, I mentioned the other day that while the Republican side had largely fought its internecine battle and come down on the side of relative pragmatism—recognizing revenue had to be raised—the Democrats had not yet gone through this process in regard to spending cuts, and it was uncertain whether they would or not.

Over the weekend, it became apparent that, at least as an opening bid, the Democrats have decided not to have that internal fight, leaving both sides in a deadlock. Mitch McConnell reported himself to have “laughed” at the White House proposal, while John Boehner pronounced himself “flabbergasted.” President Obama has declined to present another proposal until the Republicans come back to the table with a proposal of their own.

This is all terribly reminiscent of the 2011 debt ceiling negotiations, when the White House was ultimately left on the sidelines while Congressional leaders negotiated a last-minute deal. Each side blamed the other then, but it was clear the fault could be distributed all around.

The question now is whether lessons have been learned—and it seems less and less likely that they have. Coverage in the papers is trending from why we should have a deal to why it is someone else’s fault that we will not. Examples today include “Obama’s End to Giving In” on the front page of the New York Times, “Pointing Fingers and Deflecting Blame” from deeper in that paper, and “Time to Call the President’s Budget Bluff” from the Wall Street Journal op-ed page.

I remain of the opinion that this is largely political theatre and that the sides will come to some sort of an agreement—but the odds of getting a really substantive deal that would resolve the uncertainty are now much lower, and the odds of a kick-the-can deal, which just postpones the real debate, are higher.

All in all, a disappointing weekend.

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