With the market seemingly oblivious to the dismal reality of the fiscal-cliff (from a priced-in perspective) in the same way as equities trade at four-year highs while earnings are at three-year lows; it is perhaps useful to get a grasp of the maelstrom that awaits congress as they begin to tackle the fiscal-cliff on November 12. As we discussed here, the downside potential is considerable with complacency high and just as Goldman expects no real progress to be made until December (at the earliest), the market (i.e. a correction) may be the only lever to move our political elite from their respective higher ground. While talk will be of 'grand bargains', we, like Goldman, remain skeptical that any broad reform package will be completed and instead some short-term extension may be achieved. The following Q&A explains how that sausage could be made in all its gory detail.
Via Goldman Sachs:
Last week, we laid out three potential scenarios for the resolution of the fiscal cliff: the “not-so-good,” in which the payroll tax cut is allowed to expire, the “bad,” in which current policies temporarily lapse and emergency unemployment benefits and the upper-income portion of the 2001/2003 tax cuts expire, and the “ugly,” in which Congress fails to address the fiscal cliff at year's end, and does not quickly reinstate the expired policies in early 2013.
In addition to these general policy outcomes and the economic effects, a number of clients have inquired about the specific process Congress would use to extend at least some of the current policies set to expire at year's end. We address some of those questions below, in question and answer format.
Q: When will Congress return to deal with the fiscal cliff?
A: November 12. Following the Presidential and congressional elections on November 6, Congress will return the week of November 12 to begin work on a year-end fiscal package that would temporarily reverse a majority of the nearly $600bn in fiscal restraint scheduled under current law to take effect at the start of 2013. Even if they have lost their elections, current members of the House and Senate will serve out their terms until the end of the year, in what is known as the “lame duck” Congress. With an early Thanksgiving likely to make most or all of the week of November 19 unproductive, legislative debate may not begin in earnest until the week of November 26. If so, this means Congress has four weeks from the time it returns from the holiday until December 21, the latest date on which it would normally adjourn for the Christmas holiday.
Q: When would Congress actually enact the legislation to avoid the fiscal restraint scheduled for early 2013?
A: Probably not until mid-December at earliest, and quite possibly not until early 2013. Legislative debate over the last few years has been characterized by last-minute agreements, and we would not expect this year to be any different, except that we are more concerned that Congress might not reach agreement at all. For instance, in 2010 legislation to extend the 2001/2003 tax cuts, unemployment insurance, and other expiring provisions was not enacted until December 17; last year’s temporary payroll tax cut extension was not enacted until December 23.
Since Congress will not return from the election until mid-November and probably will not begin serious negotiations until after Thanksgiving, it seems likely that policy will once again remain up in the air until at least mid-December, and quite possibly until shortly before year's end.
Q: If Congress were not going to reach an agreement before year's end, when would that become apparent?
A: Unfortunately, it probably would not become clear until late December if an agreement cannot be reached. We assume that market participants will begin to form clearer views on the fiscal cliff once the uncertainty of the election outcome has been resolved. However, in light of the several near-misses in fiscal policy over the last few years, we would expect that most observers may conclude even in early or mid-December that Congress will still manage to reach an agreement, no matter how far apart the two political parties appear to be.
Q: What will actually happen during the lame duck session?
A: Public proposals followed by private negotiations. If the President wins reelection, he is likely to quickly turn his attention to the fiscal cliff. As it did last year ahead of the "super committee's" deadline, we would expect the White House to publish a formal proposal on how to resolve the fiscal cliff, probably coupled with a longer-term fiscal consolidation plan involving many of the proposals from the President's budget with perhaps a few new items. In a status quo political scenario, it is possible that congressional Republicans could offer a longer-term proposal of their own. It also appears increasingly likely that the bipartisan "Gang of Eight" senators might release a long-term fiscal reform proposal modeled after the Bowles-Simpson framework. These sort of proposals are more likely to come in the early stages of the process, followed by private negotiations punctuated with periodic press conferences from congressional leaders. On the other hand, if Gov. Romney wins the election, it is likely that the president-elect would call for a short-term extension of most of the expiring policies, making the public proposals less relevant at least in the near term.
Q: Can Congress actually put together a "grand bargain" fiscal agreement in the short time available?
A: It is difficult to see how. While a broad fiscal agreement that extends most or all of the policies set to expire while reducing the longer-term imbalance between spending and revenues would be welcome, it appears very difficult to achieve in the short time remaining before year's end, despite some recent reports that some lawmakers are attempting to put something like this together.
The main reason we are skeptical that a "grand bargain" can be reached before year's end is that resolving the complexities of health financing and other mandatory spending issues will take more than just a few weeks, as would any significant tax reform program. Furthermore, as House Speaker Boehner stated recently, since the lame duck session is a transitional period before the new Congress is seated, some lawmakers might believe it is more appropriate to wait until 2013 to negotiate the broader fiscal agreement, leaving the lame duck Congress to resolve only the pressing near-term issues.
Q: What about the "framework" for reform that has been mentioned in the press recently?
A: It is an attractive option in theory, but it faces a "chicken and egg" problem: An approach that claims to resolve this issue has been floated by members of the "gang of eight"--a bipartisan group of Senators attempting to craft an agreement similar to the Bowles-Simpson proposal from 2010. It would extend most current policies for six months, after which Congress would need to have agreed on long-term fiscal reforms. If Congress had not enacted adequate reforms by the deadline, policies similar to the Bowles-Simpson framework (e.g., increased revenues and reduced spending growth) would take effect automatically. The advantage of such an approach would be that the economy would avoid the near-term impact of the full fiscal cliff and Congress would have time in early 2013 to construct a more thoughtful reform package than is possible in the little time remaining this year, while still ensuring that the longer-term fiscal trajectory is addressed.
The drawback of this approach is that in order to create an enforceable deadline in mid-2013, Congress would need to specify before the end of the year the exact policies that would take effect if it fails to meet its targets. But if Congress were able to agree on the exact policies that would take effect in mid-2013 absent reform, it would not need to wait six months to enact them. So while such a framework is appealing in principle, it is not clear how an enforceable deadline can be set without first agreeing on taxes and spending, yet without some kind of deadline, an agreement on taxes and spending looks very difficult to achieve. The upshot is that if there is not enough time to work out a longer-term fiscal agreement by year's end, Congress may need to look for another forcing event beyond an arbitrarily imposed deadline in 2013.
Q: If Congress has not addressed the fiscal cliff by year's end, how soon can it revisit the issue?
A: Potentially in January 2013, but it will depend on the election. The new Congress will be seated on January 3, and the next presidential term will begin on January 20. In a status quo election outcome, this means Congress could continue negotiating a compromise in early January 2013 if it failed to address the fiscal cliff in December 2012, and President Obama could sign it whenever it reached his desk. In such a scenario, if Congress is not able to reach agreement in 2012, reaching a deal in early 2013 will not necessarily be that much easier, though two things will have changed that might help to facilitate a compromise: (1) public pressure on lawmakers would increase in the wake of the tax increase and spending cuts that would take effect at the start of the year, and (2) once taxes have risen, politicians would be able to claim, at least in a technical sense, that whatever compromise on the Bush tax cuts is reached would be a "tax cut." If those factors allow a political consensus to form, a retroactive extension of expired tax and spending policies could be enacted as soon as mid-January. If tax withholding had already increased by that point, it would most likely take another couple of weeks for the IRS and employee payroll processors to reverse the increase.
If, on the other hand, Congress is unable to reach agreement on the fiscal cliff in either December 2012 or January 2013, Congressional leaders would probably look to one of two other deadlines to address the issue. Under a status quo election scenario, the next obvious deadline would be the vote to raise the debt limit in either February or March. If Congress were to go that long without addressing the fiscal cliff, the effects of fiscal policy on growth would likely be worse than our "bad" scenario of a nearly 2 percentage point hit to growth, though not as severe as the 4-point hit to growth in our "ugly" scenario in which the fiscal cliff is allowed to take effect on a long-term or permanent basis.