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.”