Cliff diving

November 16, 2012 07:43 AM

An interesting thing has happened with regard to the looming fiscal cliff since the Nov. 6 presidential election results. You hear Democratic pundits downplay its importance and suggest it may not be such a bad thing and you hear those on the other side talk more about its importance.

One right leaning commentator actually complained about the rigid stance by Senate leader Harry Reid on taxes. We wouldn’t want any rigid position on taxes would we, Mr. Norquist?

Let’s talk about what the fiscal cliff is. Basically all the Bush era tax cuts and President Obama’s middle class payroll tax cut expire at the end of the year. In addition to that automatic spending cuts, sequestration, that were put in place when Congress and the Administration couldn’t agree on what to cut during the 2011 debt limit debate will hit at the same time.

The mountain of money that this double whammy will remove from the economy would slice several points of growth from GDP and lead to a recession according to the Congressional Budget Office, Federal Reserve and just about any economist you ask.  It is scary when economists agree.

But what to do? This, after all, is really the responsible thing to do; even if we arrived at it in an irresponsible manner.

Basically what happened is like two friends deciding to run a marathon but unable to agree on a training strategy, they decide not to train at all but promise that in six months’ time they will run the marathon. Not a recipe for success.

The Simpson Bowles Commission and before that a comprehensive study sponsored by the MacArthur foundation both highlighted the importance of addressing the debt issue and both also noted it will be  necessary  to address this on the revenue side and spending side. Bottom line, spending cuts or increased taxes cannot get us where we need to go, we have to do both. Actually, we need to do both in a responsible manner so that the economy can grow more robustly as we need all three: increased revenues, spending cuts and solid growth.

In fact for all the fear over sequestration, spending still goes up in subsequent years, just not at as steep a rate. While many pundits predict a delay, kicking the can down the road further, I am not sure anyone would be satisfied with that outcome, particularly the markets.

The fiscal cliff, despite all of the hyperbole, doesn’t even address the big issue, reworking entitlement programs. That is where the long-term insolvency issue kicks in.

Newedge Senior Director of Credit, Sales and Trading Larry McDonald and ACG Analytics  broke down three potential outcomes in a presentation entitled: “Beyond the Election Noise and the Fiscal Cliff."

The three outcomes are:


  • The Punt: A Deal before year end which allows many tax cuts to expire but punts the heavy lifting of a grand bargain (most likely)
  • Go Off the Cliff: $660 billion tax increase + spending cuts = 4.6% hit to GDP, hard recession (not likely)
  • A mega deal Grand Bargain before year end (will not happen)

The report dismissed the idea of a grand bargain and broke down the punt into these three scenarios:

  • We get a deal between Dec.  20-22 with $220 billion of expiring tax increases and spending cuts; 1.4% of U.S. GDP, a hit to GDP of 1%.
  • Deal Reached between Dec. 26-31 with same terms.
  • We bounce off the cliff Lehman style and get a quick deal in January when the House and Senate come back into session.

The last time the decision on taxes came to a head, a compromise was made that sacrificed fiscal discipline to extend tax cuts on upper income folks and extend jobless benefits out to 99 weeks.

At the time we noted that if either side were serious about deficit reduction, they would sacrifice something they wanted to achieve it. While it seems wise to moderate the effects of the fiscal cliff, i.e. just raise taxes on top earners and phase in cuts over longer period of time, any deal should require both sides to give something they want to reduce the deficit while trying to avoid another recession.

In fact a year ago BlackRock’s Global Head of Fixed Income Peter Fisher made the point that what was necessary is to cut long-term liabilities—i.e. fix social security and Medicare— but not cut spending too much in the near-term with a weak economy.  

The report states that punting brings in the possibility of a ratings downgrade and, “ACG Analytics believes that a deal which will increase taxes, blunts the sequester, and formalizes a framework and expedited process for tax and entitlement reform will be completed before the end of the year, though it will not be a smooth process, likely producing increased market volatility right up until the deal becomes law.”

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.