In the past it has been the bond market whose vigilantes had rampaged across the fields to keep policymakers honest - but something has changed with the Fed's boot on the bond market. As BofAML notes, when the Fed was too soft on inflation or the fiscal deficit was out of control, interest rates spiked higher. In our view, this has changed and today the stock market is the disciplining force for Washington. We have argued this perspective for a while - that nothing will be done until we get a stock market crash - but the press will continue to make molehills out of mountains it seems as BofAML adds, the most obvious lesson of the last week is that when Washington approaches a policy impasse, the financial press tends to signal a resolution of the crisis many times before it happens. Don’t believe it. After elections there is always conciliatory talk: no one wants to be seen as a sore loser or a gloating winner. The risk remains huge and the four hurdles to a grand bargain seem to be getting larger - no matter what the press wants us to think.
Via BofAML: Taxing Negotiations
In the past week, Democrats and Republicans have staked their initial negotiating position on the fiscal cliff. The news is not encouraging. As our regular readers know, we expect a complex negotiation process that takes many months and multiple brinkmanship moments before full resolution of the cliff. The news in the last week confirms several of our concerns.
Perhaps the most obvious lesson of the last week is that when Washington approaches a policy impasse, the financial press tends to signal a resolution of the crisis many times before it happens. This was evident in the first few days after the election. In his acceptance speech, the President said: “You elected us to focus on your jobs, not ours. And in the coming weeks and months, I am looking forward to reaching out and working with leaders of both parties to meet the challenges we can only solve together.” On a similar note, House Speaker Boehner said “Republicans have signaled a willingness to accept new revenue if it comes from growth and reform.” These positive statements prompted several days of optimistic headlines.
Don’t believe it. After elections there is always conciliatory talk: no one wants to be seen as a sore loser or a gloating winner. Moreover, surveys show the US public wants politicians to start working together. However, we believe investors should look past reassuring rhetoric and focus on the underlying reality. Recent budget impasses have virtually always gone to the last minute and sometimes beyond. In the latest incarnation, the two sides have dug in their heels on income taxes and have not even started to discuss the rest of the cliff. The disagreements between the two parties run very deep and neither side wants to give ground until it has to. The stakes are particularly high in the first round of negotiations: policy steps today could set the tone for the next several years.
Wile E. Coyote moment
The recent commentary also underscores the risk of going over the cliff before a compromise is reached. As we have noted before, in the run up to the election a wide range of commentators were suggesting that going over the cliff is not such a bad idea. They argue: (1) it won’t hurt the economy if it is temporary, (2) it is a good way to extract concessions from the opponents, (3) it resets the starting point for debate (it is easier to restore tax cuts and rescind spending cuts than to do the opposite), and (4) it allows time to get a better crafted deal. In his first press conference after the election, President Obama hinted that he, too, might be willing to go over the cliff, arguing that that raising taxes on the wealthy must be the first step in any budget deal. Keep in mind that the path of least resistance is down: it is much easier for one party to block legislation, and go over the cliff, than to forge a compromise and avoid the cliff. Some people argue that the weak showing of Republicans in the elections means they will be more inclined to compromise, reducing the risk of going over the cliff.
We are not so sure. After all, the Republicans need to first sort out why they did poorly. Moreover, while the election result may have softened the Republican position, there are plenty of early signs that it has stiffened the backbone of Democrats. For example, President Obama has repeatedly argued that the election is a “very clear mandate” to raise taxes on the wealthy. By contrast, Republican vice presidential candidate Paul Ryan said that there is no such mandate because the public also “reelected the House Republicans.” Are the two sides closer together or farther apart? It is hard to say, but clearly the gap remains very big.
The Grand Distraction
The post-election discussion underscores the futility of trying to get a quick “grand bargain,” putting in place a long-term plan for deficit reduction. Speaker Boehner has emphasized that any increase in tax revenues should come from broad-based reform: “in order to garner Republican support, the President must be willing to reduce spending and shore up the entitlement programs that are the primary drivers of our debt.” While tax and entitlement reform are good long term goals, are they really feasible in a few months?
A near-term grand bargain faces not just one, but four major hurdles:
- A low starting point: Neither party has even scratched the surface in presenting a feasible plan for either tax or entitlement reform, in our view. Tax reform requires tough choices around which loopholes to cut, a topic that has been carefully avoided by both parties. Medicare reform also requires tough choices around how care is rationed. Republicans have offered a voucher plan, but haven’t mentioned that it will only reduce costs if patients have large out-of-pocket expenses so they have an incentive to limit their spending. Democrats have offered to cut payments to providers, but without any impact on service. The American public needs to be educated about the true options it faces.
- Bi-partisan cooperation: As was clear in the 1986 tax reform, getting complicated and contentious reforms enacted is very hard without true cooperation, particularly with relatively evenly divided government. The leaders of the two parties have to stand together and fight the special interests.
- High complexity: The US tax code is extremely complicated and any attempt to change it creates many winners and losers. It has big impacts on the many special interests with tax advantages. It also redistributes income across not just income classes but between states (ironically, high-income people in the “Blue states” that voted for the Obama have the most to lose since those states tend to have high mortgages and high state and local taxes). If anything, Medicare reform is even more difficult since it involves life and death choices and there are fundamental disagreements about the relative role of markets and administration in controlling costs.
- A sizable gap in view: The two parties strongly disagree about how tax reform impacts the economy. Republicans argue that most of the revenue from tax reform will come from creating a stronger economy. In the past week, President Obama countered: "What I will not do is to have a process that is vague, that says we're gonna sorta, kinda raise revenue through dynamic scoring or closing loopholes that have not been identified."
We agree that it is important to start laying the ground work for tax and entitlement reform, but we also believe it is also important to get the sequencing right. First, dismantle the fiscal cliff, and then start negotiations on the longer term solutions.
Stock market “vigilantes”
Historically the bond market has been a disciplining force for policymakers. When the Fed was too soft on inflation or the fiscal deficit was out of control, interest rates spiked higher. In our view, this has changed and today the stock market is the disciplining force for Washington. Stocks have generally endorsed Fed policy. We estimate that stock prices rose a cumulative 15% in the past three years in response to Fed announcements or actions. While some investors have misgivings about what the Fed is doing, the overall market likes it. By contrast, the stock market is giving a clear no-confidence vote to fiscal policymakers. This was particularly clear when the TARP bailout plan failed to pass and at the end of the debt ceiling debate.
Today, the stock market “vigilantes” are gathering again. In early September we argued that “there is a high risk of a risk-off trade in the markets after [the Fed meeting on] September 13.” We argued that market focus would shift from Fed and ECB easing to fiscal policy risks. In the event the Fed meeting did mark a turning point in the markets, and with the election over and the fiscal cliff taking center stage, the downward pressure has accelerated (Chart 1). This weakness has occurred despite better news on the economy and an unremarkable earnings season.
The fiscal cliff is unlikely to be resolved quickly or in a completely benign fashion. Our advice:
“fasten your seatbelts and remain seated until Co-pilots Obama and Boehner turn off the fasten seatbelt sign.”
In particular, we would be leery about a big air pocket in late December, when our political pilots decide whether sharply drop altitude or not.