The Fiscal Cliff

With the global economy reeling from the European debt crisis, another impediment to the world’s economic well-being has been, until recently, less frequently referenced. In January 2013, $1.2 trillion in automatic spending cuts are scheduled and a series of tax cuts enacted under the Bush ’43 administration are set to expire. This scenario, known colloquially as “The Fiscal Cliff”, would likely cause catastrophic damage to the global economy and roil markets. Included among the changes scheduled to take place are a rise in payroll taxes, which will immediately lower take-home wages, a sharp increase in the number of taxpayers that will see their taxes increase as a result of being required to pay the alternate minimum tax rate (AMT) and a slashing of spending on both domestic programs and defense.[1] According to the International Monetary Fund (IMF), if the Fiscal Cliff is not avoided, the U.S. recovery could be wiped out, with significant economic consequences resulting for the rest of the world. The IMF predicts a 3.9% drop in the U.S. growth rate which would send the American economy back into a recession.[2]

With the U.S. economy’s recovery already tepid at best, it can ill afford another headwind with which to deal. According to both the IMF and professional investors one of the primary reasons that GDP growth has been mediocre is the uncertainty associated with what tax rates and government spending levels will be. As a result of this uncertainty, businesses are curtailing hiring and capital investments and taking a “wait and see approach” according to Jack Ablin, chief investment officer at Harris Bank.[3] In short, the ill effects of the impending Fiscal Cliff are already having an impact, slowing economic growth as businesses hedge their bets in anticipation of a long, ugly, partisan political struggle that few have confidence will result in a compromise or a long term plan that addresses the structural changes necessary to heal the domestic economy. Labeled “uncertainty shock” by some, it is already in place and will likely accelerate between now and the elections in November.[4]

In early July, while testifying before Congress, Federal Reserve Chairman Ben Bernanke warned lawmakers that "fiscal decisions should take into account the fragility of the economy." The politicians, he made clear, hold the ability to avoid the approaching calamity and should take into account the consequences if they allow partisan bickering to short circuit a compromise which, according to the Congressional Budget Office (CBO), would most likely allow modest economic growth to continue. It is unlikely that such a compromise will be reached given the political gridlock of Washington D.C. and it is that knowledge, that lack of confidence in the ability of U.S. leaders to do their jobs with competency that has led to the current level of uncertainty, one which represents as great a threat, perhaps even greater, than that of the ongoing European sovereign debt crisis. A repeat of the brinkmanship of last year’s debt ceiling crisis is feared and is now being factored in by the markets, businesses and individuals throughout the economy in how they both spend and save.[5]

Even if a compromise can be reached, the process will likely be messy, which would only serve to further undermine what little confidence the American electorate, and investors, have in U.S. politicians. The political and economic situation domestically mirrors that of Europe, as equivocation, hyperbole and a distinct lack of will to act decisively are held to be the hallmarks of leaders on both sides of the Atlantic. Additionally, with the selection of Paul Ryan as the vice-presidential candidate and running mate of Mitt Romney, the odds against a compromise have increased even further. Many analysts and investors feel that given Ryan’s passion for his proposed budget plan, which calls for large spending cuts in an effort to cut the deficit, that Republicans will be even more intransigent and opposed to cutting a deal with Democrats than they would have with a less ideologically driven VP. Ryan’s budget plan has effectively been endorsed by the Romney campaign, although the presidential candidate has issued some qualifying statements in recent days as to his whole hearted support of all its tenets. Markets hate political uncertainty; reference the 16.8% drop of the S&P 500 in the summer of 2010 within days of the debt ceiling crisis resulting in the downgrade of the United States credit rating.[6]

For the foreseeable future, interest rates will remain low as investors seek safe haven for their money in U.S. Treasuries, a trend that could be augmented by the implementation of QE3 by the Federal Reserve. Those borrowers able to qualify for loans under the current tighter lending practices that are willing to take on debt in a climate of such pronounced instability will benefit. It is more likely, however, that low interest rates will fail to entice borrowers in sufficient numbers to provide any meaningful stimulus to the economy.