The Independent Market Observer

12/5/12 – Some Thoughts About Going Over the Fiscal Cliff

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Dec 5, 2012 12:30:09 PM

and tagged Fiscal Cliff, Politics and the Economy

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Much of the coverage today is about the difficulties facing the fiscal cliff negotiations. These stories suggest that I may have been premature in thinking the Republicans had fought their own civil war to completion. Although the House Republicans did indeed offer a compromise plan, and the leadership did indeed sign on, the battle still seems to be under way.

As part of that battle, Speaker Boehner has kicked four of the more conservative members of his caucus off of desirable committees—a serious punishment—for not falling in line. They won’t be going away, though, and the question now is how many of their colleagues will join them. Senator McConnell refused a chance to endorse the Boehner offer, and Senator DeMint actively rejected it.

The fact that there is this much conflict in the Republican Party suggests that the offer may be as far as they can go. Since the White House has already rejected that offer, there’s a chance that we will not be getting a deal of any sort before the end of the year.

I emphasize again that this may well be political theatre, and it may be that the increased noise level means negotiations are getting serious. But the reverse may also be true, and I get the sense that the preparation for failure is getting more serious as well.

The Federal Reserve, for example, is widely expected to maintain asset purchases in an effort to continue to stimulate the economy—just in case. Boehner’s punishment of dissidents could be read as an attempt to insulate the Republican Party as a whole from the blame by creating preemptive scapegoats. In fact, articles over the past several days have highlighted various attempts to minimize failure or avoid blame: Monday brought “Pointing Fingers and Deflecting Blame” and “Some Analysts Doubt Dire Predictions on Tax Increase Fallout” in the New York Times; Tuesday had “Negotiators, Cliff Divers Are Racing Each Other” and “Despite the Name, Drop Not So Steep” in the Wall Street Journal; and today, we have “Weighing Consequences of a Temporary Dive Off Cliff,” also in the WSJ.

The spin here is that going over the edge wouldn’t be so bad—the argument being that the actual effect of the increased tax withholding would be gradual, and that certainly the new Congress would come to an agreement quickly. I disagree.

There are two faulty assumptions at work. The first is that the effect would be gradual. For lower-income earners, the expiration of several tax breaks would hit their take-home pay immediately through higher withholding. Because people in this bracket typically spend most or all of what they make, the hit to consumer demand would be immediate, although it might not show up in the statistics at first. The effect on consumer confidence would also be immediate for the same reason—and potentially hard to reverse.

The second faulty assumption is that the new Congress would be more successful at concluding a deal than the current Congress. There are good reasons to think the reverse, and failure now would probably poison the well for the next Congress as well. We have already seen the conservative blowback for the existing Boehner proposal. How much more willing will the Republicans be to deal if that does not succeed? Failure now would probably make next year’s negotiations even more painful.

Finally, what no one is talking about yet is the pending federal debt ceiling increase. With the conflict level rising, the notion of trying to negotiate a new agreement on taxes at the same time as trying to raise the debt ceiling is, at the least, challenging. Remember the last time we went through this?

Overall, I believe there is still an incentive and a need to cut a deal, and I certainly think that both parties are actively working to do so. Every time the conflict ratchets up, though, the chances of a deal before the end of the year decline, and the difficulties of crafting a solution in the new Congress increase. Let’s hope the increased noise level actually means a deal is getting closer.

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