12/31/12 – Here We Go

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 31, 2012 8:13:07 AM

and tagged Fiscal Cliff

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At the end, when all’s said and done, much more is said than done. Today, the deadline for averting the fiscal cliff, we certainly see that in spades.

It’s not the end of the world—that will be next year, if Congress refuses to raise the debt limit and the U.S. defaults—but it isn’t good.

The image that keeps coming to mind is the slow-motion disaster in Austin Powers: The Spy Who Shagged Me, where he screams for about 10 minutes before almost getting crushed by a very slow-moving steamroller. The reason I keep thinking of it isn’t the slow-motion pace, or the fact that anyone with any sense would have stepped out of the way—although both are relevant to our current situation—but the sheer absurdity of the scene. Seeing a version of it unfold in real life just brings that out even more strongly.

So what happens now?

  1. Tax withholding goes up. Everyone’s paychecks get smaller starting tomorrow morning. Disposable income goes down. The lower income tranches get hit the hardest, proportionately, and since people in that group spend most of their income immediately, the effect will be larger than expected.
  2. Business gets even less confident. Investment has tanked over the past six months as businesses waited for uncertainty in Washington to clear up. Instead, it has gotten worse, and investment and hiring have slowed even further. This headwind is not going away any time soon.
  3. Employment takes an immediate hit, as government spending and programs are slashed. According to the Wall Street Journal, the Pentagon alone plans to notify 800,000 civilian employees that they may have to take weeks of unpaid leave.
  4. The well is poisoned for the real negotiation, in a couple of months, on raising the debt ceiling. As bad as the fiscal cliff may be, it has redeeming qualities. The debt ceiling negotiation has only risks. Based on past and current experience, that will hit the economy and markets even harder than the current debacle.
  5. The other deal that needs to be cut, resetting the alternative minimum tax thresholds, gets harder as well. Millions of households will be looking at much higher tax bills in April unless the thresholds are reset.

All of this would result in limited immediate damage if a deal were to be cut quickly in the New Year. So, to some extent, the fuss over the year-end deadline is overdone. That said, if lawmakers have not been able to do a deal under deadline pressure, I don’t see how they will be more motivated when the deadline is removed.

Resolving the fiscal cliff, in some form, has to happen. Doing it immediately and using a meat ax to make the necessary cuts is probably the worst way to go about it, but there will be benefits. The deficit will decline as tax receipts increase and spending decreases. Arguably, cutting the deficit, even in such a ham-handed way, will in itself increase growth. Cutting some type of deal may well become easier since, under the new laws, any changes will be tax reductions rather than tax increases. Finally, as the negative economic effects mount, pressure on lawmakers will increase. I do expect some form of resolution, and I hope it will be quick, but I’m less confident than I was a couple of weeks ago.

While there’s no need to panic here, there are grounds for serious concern. A great deal of damage has been done by the prolonged debate, and it will get worse once the deadline passes. The biggest danger to the ongoing recovery is almost here, and we will have to see just how bad it is.

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