12/3/12 – On the Other Hand . . .

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

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

and tagged Fiscal Cliff, Politics and the Economy

Leave a comment

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.

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®